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Full text of "Private litigation under the federal securities laws : hearings before the Subcommittee on Securities of the Committee on Banking, Housing, and Urban Affairs, United States Senate, One Hundred Third Congress, first session, on a growing increase in class-action securities litigation against publicly-traded companies, particularly high technology, accountants, outside directors, and lawyers, June 17 and July 21, 1993"

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PRIVATE LITIGATION UNDER THE FEDERAL 
SECURITIES LAWS 





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Private Litigation Under the Federa... L 

iNGS 

BEFORE THE 

SUBCOMMITTEE ON SECURITIES 

OP THE 

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED THIRD CONGRESS 

FIRST SESSION 

ON 

A GROWING INCREASE IN CLASS-ACTION SECURITIES LITIGATION 
AGAINST PUBLICLY-TRADED COMPANIES, PARTICULARLY HIGH TECH 
NOLOGY, ACCOUNTANTS, OUTSIDE DIRECTORS AND LAWYERS 



JUNE 17 AND JULY 21, 1993 



Printed for the use of the Committee on Banking, Housing, and Urban Affairs 



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S. Hrg. 103-431 

PRIVATE LITIGATION UNDER THE FEDERAL 
SECURITIES LAWS 



HEARINGS 

BEFORE THE 

SUBCOMMITTEE ON SECURITIES 

OF THE 

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED THIRD CONGRESS 

FIRST SESSION 

ON 

A GROWING INCREASE IN CLASS-ACTION SECURITIES LITIGATION 
AGAINST PUBLICLY-TRADED COMPANIES, PARTICULARLY HIGH TECH- 
NOLOGY, ACCOUNTANTS, OUTSIDE DIRECTORS AND LAWYERS 



JUNE 17 AND JULY 21, 1993 



Printed for the use of the Committee on Banking, Housing, and Urban Affairs 




U.S. GOVERNMENT PRINTING OFFICE 
76-761 CC WASHINGTON : 1994 

For sale by the U.S. Government Printing Office 
Superintendent of Documents, Congressional Sales Office, Washington, DC 20402 
ISBN 0-16-043911-6 



COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

DONALD W. RIEGLE, JR., Michigan, Chairman 

PAUL S. SARBANES, Maryland ALFONSE M. D'AMATO, New York 

CHRISTOPHER J. DODD, Connecticut PHIL GRAMM, Texas 

JIM SASSER, Tennessee CHRISTOPHER S. BOND, Missouri 

RICHARD C. SHELBY, Alabama CONNIE MACK, Florida 

JOHN F. KERRY, Massachusetts LAUCH FAIRCLOTH, North Carolina 

RICHARD H. BRYAN, Nevada ROBERT F. BENNETT, Utah 

BARBARA BOXER, California WILLIAM V. ROTH, JR., Delaware 

BEN NIGHTHORSE CAMPBELL, Colorado PETE V. DOMENICI, New Mexico 

CAROL MOSELEY-BRAUN, Illinois 

PATTY MURRAY, Washington 

STEVEN B. HARRIS, Staff Director and Chief Counsel 

HOWARD A. MENELL, Republican Staff Director 

Edward M. Malan, Editor 



Subcommittee on Securities 

CHRISTOPHER J. DODD, Connecticut, Chairman 

JIM SASSER, Tennessee PHIL GRAMM, Texas 

RICHARD C. SHELBY, Alabama WILLIAM V. ROTH, JR., Delaware 

RICHARD H. BRYAN, Nevada CHRISTOPHER S. BOND, Missouri 

CAROL MOSELEY-BRAUN, Illinois LAUCH FAIRCLOTH, North Carolina 

PATTY MURRAY, Washington PETE V. DOMENICI, New Mexico 

Martha L. COCHRAN, Staff Director and Chief Counsel 

MICHAEL J. STEIN, Financial Policy Analyst 

GEORGE KRAMER, Special Counsel 

Ira Paull, Republican Counsel 

LAURA SlMONE UNGER, Republican Counsel 

WAYNE A ABERNATHY, Republican Economist 

(II) 



CONTENTS 



THURSDAY, JUNE 17, 1993 

Page 

Opening statement of Senator Dodd 1 

Opening statements, comments, or prepared statements of: 

Senator Riegle 3 

Senator Domenici 4 

Prepared statement 87 

Senator Kerry 89 

Senator Shelby 6 

Senator Faircloth 7 

Senator Bryan 8 

Senator D'Amato 8 

Senator Bennett 9 

Senator Moseley-Braun 27 

WITNESSES 

Edward R. McCracken, president and chief executive officer, Silicon Graphics, 

Inc., Mountain View, CA 10 

Prepared statement 91 

Response to written questions of: 

Senator Sasser 183 

Senator Bryan 185 

Senator Domenici 187 

John G. Adler, president and chief executive officer, Adaptec, Inc., Milpitas, 

CA 14 

Prepared statement 103 

Response to written questions of: 

Senator Sasser 189 

Senator Bryan 192 

Senator Domenici 224 

Richard J. Egan, chairman, EMC Corporation, Hopkinton, MA 16 

Prepared statement 108 

Two frivolous lawsuits 108 

Implications for public companies, investors, and the U.S. economy ... 109 

Remedying the situation 109 

Response to written questions of: 

Senator Sasser 225 

Senator Bryan 228 

Senator Domenici 238 

Thomas Dunlap, Jr., general counsel, Intel Corporation, Santa Clara, CA 18 

Prepared statement 110 

Intel: High technology company 110 

Intel growth 110 

September, 1991, litigation 110 

April, 1993, litigation Ill 

Expenses Ill 

Response to written questions of Senator Domenici 240 



IV 

Page 

William R. McLucas, director, Division of Enforcement, SEC, Washington, 

DC 36 

Prepared statement Ill 

The Commission's enforcement program 112 

The importance of private actions 113 

Assessing the need for litigation reform 114 

Proposals for litigation reform 115 

Conclusion 120 

Mark J. Griffin, director, Securities Division, Department of Commerce, Salt 

Lake City, UT 40 

Prepared statement 122 

Overview and executive summary 122 

The role of private actions in securities law enforcement 124 

Recommendation: Lengthen the statute of limitations 125 

Private actions and frivolous suits 127 

General comments on proposals to reform securities litigation 129 

Response to written questions of Senator Sasser 242 

Joel Sekgman, University of Michigan Law School, Ann Arbor, MI 41 

Prepared statement 130 

Patricia Reilly, AG Edwards Company, San Diego, CA 44 

Prepared statement 132 

I. Pace membership warehouse 134 

II. Tucson Electric Power 135 

Possible solutions 136 

Response to written questions of: 

Senator Sasser 246 

Senator Domenici 256 

Vincent E. O'Brien, Law and Economics Consulting Group, Inc., Emeryville, 

CA 46 

Prepared statement 138 

Response to written questions of: 

Senator Bryan 248 

Senator Domenici 256 

William S. Lerach, San Diego, CA 66 

Prepared statement 141 

Response to written questions of Senator Sasser 269 

Gordon K. Billipp, Jeffrey, NH 69 

Prepared statement 163 

Response to written questions of Senator Sasser 277 

Russell E. Ramser, Jr., Maram Energy Company, Mount Vernon, OH 72 

Prepared statement 168 

Response to written questions of Senator Sasser 278 

Edward J. Radetich, CPA, president, Heffler & Company, Philadelphia, PA .... 75 

Listing of claim information 173 

Cases Deing handled 178 



WEDNESDAY, JULY 21, 1993 

Opening statement of Senator Dodd 279 

Opening statements, comments, or prepared statements of: 

Senator Riegle 281 

Senator D'Amato 282 

Senator Domenici 282 

Prepared statement 344 

Senator Bennett 284 



V 

Page 

WITNESSES 

W.J. "Billy" Tauzin, U.S. House of Representatives, District 3, Louisiana 285 

Ron Wyden, U.S. House of Representatives, District 3, Oregon 288 

Jake L. Netterville, chairman of the board, AICPA, Baton Rouge, LA 299 

Prepared statement 346 

Response to written questions of: 

Senator Domenici 426 

Senator Bryan 451 

A. A. Sommer, Jr., chairman, Public Oversight Board, AICPA, Washington, 

DC 302 

Prepared statement 351 

Response to written questions of: 

Senator Domenici 456 

Senator Bryan 459 

Ralph V. Whitworth, president, United Shareholders Association, Washing- 
ton, DC 304 

Prepared statement 364 

Response to written questions of: 

Senator Domenici 461 

Senator Bryan 463 

Abraham J. Briloff, Ph.D., professor emeritus of accounting, Baruch College, 

CUNY, New York, NY 308 

Prepared statement 365 

Melvyn I. Weiss, Esquire, partner, Milberg Weiss Bershad Hynes & Lerach, 

New York, NY 311 

Prepared statement 398 

Response to written questions of Senator Domenici 465 

Robert A. Bowman, executive vice president and chief financial officer, Finan- 
cial Executives Institute, New York, NY 314 

Prepared statement 411 

Marc E. Lackritz, president, Securities Industry Association, Washington, 

DC 316 

Prepared statement 412 

Response to written questions of Senator Domenici 547 

Ralph Nader, Public Citizen, Washington, DC 318 

Prepared statement 422 

Maryellen F. Andersen, Council of Institutional Investors, Hartford, CT 322 

Prepared statement 424 

Response to written questions of Senator Domenici 565 

Additional Material Supplied for the Record 

AG Edwards Company, Patricia Reilly: 

Letter dated July 5, 1993 567 

Letter dated July 11, 1993 574 

Intel Corporation 577 

Vitesse 577 

Seagate 581 

National Venture Capital Association 583 

Adaptec 585 

EMC Corporation 586 

Silicon Graphics 588 

Sun Microsystems, Inc 590 

SEC, letter to Senator Domenici dated June 12, 1992 598 

SEC, letter to Senator Domenici dated August 12, 1992 600 

Newspaper and magazine articles 602 

ZEOS International, Ltd 612 

American Institute of Certified Public Accountants 614 

Sisco Associates Management Consulting Firm 644 



VI 

Page 

Public Citizen: 

News Release, July 21, 1993 647 

Bad Audits— Not Deep Pockets 649 

United States Public Interest Research Group 650 

Mayer, Brown & Piatt, letters dated: 

June 11, 1993 662 

July 1, 1993 700 

August 6, 1993 708 

October 18, 1993 729 

September 24, 1993 730 

University of California, Berkeley : 674 

American Business Conference, American Electronics Association, American 
Institute of CPA's, Association of Publicly Traded Companies, and National 

Venture Capital Association 720 

NASCAT 727 

NERA 739 

James M. Newman 776 

Gilardi & Co 783 

ADAPTEC 793 

Public Oversight Board 795 

Milberg Weiss Bershad Specthrie & Lerach, letters dated: 

June 23, 1993 796 

July 6, 1993 798 

July 16, 1993 804 

August 17, 1993 836 

August 18, 1993 855,884 

August 19, 1993 871 

August 27, 1993 884 

Princeton Venture Research, Inc 878 



PRIVATE LITIGATION UNDER THE FEDERAL 

SECURITIES LAWS 



THURSDAY, JUNE 17, 1993 

U.S. Senate, 
Committee on Banking, Housing, and Urban Affairs, 

Subcommittee on Securities, 

Washington, DC. 

The subcommittee met at 9:55 a.m., in room SD-538 of the Dirk- 
sen Senate Office Building, Senator Christopher J. Dodd (chairman 
of the subcommittee) presiding. 

OPENING STATEMENT OF SENATOR CHRISTOPHER J. DODD 

Senator Dodd. The hearing will come to order. 

It's standing room only here. We appreciate everyone coming out 
this morning. It must be a matter of some interest to provoke this 
kind of attendance this morning. 

Let me welcome everyone to our hearing this morning on private 
securities litigation. Today, we will examine what some have said 
is a growing and unjustified increase in securities litigation against 
high technology companies, accountants, outside directors and law- 
yers. 

Critics of the current system argue that legislation is necessary 
to limit excessive litigation. This issue has generated enormous 
controversy. I hope this morning we can lower the level of rhetoric 
and examine the facts and consider this issue in terms of fun- 
damental public policy goals. 

Clearly, the policy goal of Federal securities laws is to promote 
investor confidence and thereby encourage the kind of investments 
necessary for capital formation, economic growth and job creation. 
Investors must believe that the markets are fair, and that when 
they invest in a company's securities, they have all the material 
facts. 

We're not promising investors that their investments will be risk- 
free, but we are saying that investors should be informed of the 
risks. A strong enforcement program by the SEC is an essential 
part of the investor protection system. Over the years, Chairman 
Riegle and this committee have worked extremely hard to ensure 
that the SEC has sufficient funds to hire the lawyers and examin- 
» ers to do their jobs. Three years ago, with Chairman Riegle's help, 
the subcommittee developed and moved through the Senate the Se- 
curities Law Enforcement Remedies Act, which gave the SEC 
greater authority to prosecute fraud, to impose fines, and to recover 
money for investors. 

(l) 



But the SEC needs help in recovering investor losses and in de- 
termining law violations. For many years, the Congress, the courts, 
and the SEC have supported the concept of private investor law- 
suits under the Federal securities laws. Investors who are injured 
by fraudulent activity do not have to rely on the SEC to recover 
their losses. They can take action on their own, and they should 
be able to do so. 

These private lawsuits are critical to the overall scheme of law 
enforcement because, like the SEC enforcement actions, they help 
to deter future violations. 

When the system is working well, it helps to keep corporate offi- 
cers honest and helps ensure that auditors, directors, lawyers and 
others do their jobs, and therefore promotes investor confidence 
and capital formation, the two critical issues I mentioned at the 
outset of these remarks. 

But many of our witnesses this morning are going to tell us 
something else, that securities litigation has gotten out of hand and 
is destroying the very capital formation policy it seeks to promote. 
They say cases are brought without any investigation. Complaints 
are literally run off word processors within days or even hours of 
a drop in a company's stock and are brought for the purpose of ex- 
tracting settlements. 

They argue that this has drained money and energy from our 
job-creating industries. Accountants say that they are automati- 
cally joined as defendants because of their deep pockets and that 
they may be held liable for a disproportionate share of the actual 
losses. 

Some shareholders say that while class actions result in enor- 
mous fees for plaintiffs' lawyers, shareholders get only a fraction of 
their actual losses. We are going to examine these charges today 
and in our hearing next week. There are several questions that 
we've got to ask. 

First, we need to determine the validity of these claims. Are 
there large numbers of lawsuits filed that have no merit in fact? 

While there is a great deal of anecdotal evidence, up to this 
point, we have not had the kind of hard evidence that we need to 
make a case for legislation. So we need to get all of the facts. 

Second, we need to ask why the current system doesn't work to 
weed out meritless litigation. The courts have plenty of tools to use 
at their discretion — rule 11, summary judgments, special rules re- 
lated to class actions. 

We need to examine in this committee whether these tools are 
working as they should and if not, what can be done to improve 
them? 

Third, we need to determine if legislation is necessary. We need 
to consider what kinds of changes can address the problem of frivo- 
lous litigation, yet still leave effective remedies for victims of fraud. 

And finally, we need to ask whether additional steps should be 
taken to enhance the rights of investors and to deter financial 
fraud. 

It has been suggested that when you get into these questions, 
you have to be either for the accountants or for the trial lawyers 
or for some other group. 



Let me just speak for myself. We're for people who are investors. 
We are for companies who want to grow. We're for people who need 
protection from fraud. 

This is not going to be a process where we choose up sides be- 
tween one particular interest group or another. I can only hope 
that we avoid those characterizations this morning and next week. 
I believe that we're all after the same goals and want to see these 
hearings conducted in that manner. 

Chairman Riegle, Senator Domenici and our other colleagues are 
all, I feel, of a similar mind. Our goal is to examine the system we 
have which is so vital to investor confidence and to make sure that 
it is operating in the fairest possible manner. 

I look forward to hearing from our witnesses on these important 
matters and I want to thank all of you for coming this morning. 

Let me begin by first of all apologizing to our witnesses. We had 
a vote that we did not know about that was scheduled last evening, 
and so we're all delayed in getting over here. But I'm deeply grate- 
ful to the Chairman of the Full Banking Committee for his pres- 
ence here this morning. And I know, as a Member of the Finance 
Committee, he has some other matters that he has to address. So 
I thank him for coming by and we'll defer to you at this moment, 
Mr. Chairman, and then 1 11 turn to my colleague from New Mexico. 

OPENING STATEMENT OF SENATOR DONALD W. RIEGLE, JR. 

The Chairman. Thank you very much, Chairman Dodd. And let 
me thank my Republican colleagues, too, for their courtesy. 

Certainly, we have a large and distinguished panel of witnesses 
before us this morning and I regret that I can't stay for the hear- 
ing, but I do want to make some opening comments. 

First, I want to commend you, Senator Dodd, for your continuing 
leadership on the Subcommittee on Securities and for this morn- 
ing's hearing, which I think is an important example of the way 
you lead that area of work in our committee. 

The United States has the most vibrant capital markets in the 
world. We also have the most open legal system. They are great 
strengths and attributes of our system. Today's hearing will review 
really the tension between these two great American strengths. 

Concerns have been raised about securities litigation, notably, by 
high technology companies and the accounting profession. They 
argue that the United States is suffering an explosion of securities 
fraud litigation, much of it meritless. 

Companies, particularly growth firms, say they are sued when- 
ever their stock drops. As the cost of defending such suits is high, 
companies may settle regardless of the merits. This raises the cost 
of capital formation and putting our firms often at a competitive 
disadvantage. 

The accounting profession also criticizes the way liability for se- 
curities fraud is assessed. Under joint and several liability, an in- 
vestor who's been defrauded may recover his or her entire loss from 
any one defendant, even if others orchestrated the fraud. 

Accountants argue that because the perpetrators of securities 
fraud typically have no assets by the time the lawsuits are filed, 
accounting firms typically and frequently are the major source of 
recoveries. The accountants suggest tnis unbridled liability is 



threatening their ability to serve America's businesses. According 
to this line of argument, reluctance on the part of the accounting 
profession to audit growing companies for fear of liability is also re- 
straining capital formation. 

Then, on the other hand, there is a sizable body of opinion hold- 
ings these concerns must be balanced against the goals that are ad- 
vanced by private securities fraud suits. Proponents of the current 
system note private securities fraud suits are the most important 
method of compensating victims of securities fraud. They also deter 
additional violations. 

As the SEC's Director of Enforcement will testify this morning, 
and I quote: 

The implied private right of action under section 10(b) and rule 10(bX5) there- 
under is critically important to the effective operation of the Federal securities law. 

A very important statement, I think. 

He and others will testify that our capital markets are so deep 
in large part because investors know they can seek restitution in 
cases of fraud. Any steps to reduce the number of frivolous lawsuits 
should not deny deserving plaintiffs their day in court. 

While considering the claims of a dangerous explosion in litiga- 
tion, it is important to keep in mind the following. Initial public of- 
ferings of stock have been proceeding at a record pace. The $11.5 
billion raised in IPO's in the first quarter of 1993 topped the pre- 
vious record of $11 billion set in the first quarter of 1992. 

Safeguards are available to prevent meritless lawsuits. These in- 
clude class certification requirements, sanctions against attorneys 
who file baseless proceedings, and fee-shifting in abusive cases. 

According to the Big Six accounting firms, just 30 percent of the 
lawsuits pending against them in 1991 contained rule 10(b)(5) 
claims. Accountants are liable for securities fraud only if they act 
recklessly or with actual knowledge of the fraud. 

It is important that all sides of these issues be aired fully and 
as I indicated, I think we have a genuinely excellent panel with 
which to do that. 

I'm especially pleased to welcome Professor Joel Seligman of the 
University of Michigan Law School, one of the Nation's premier se- 
curities law experts. 

Thank you. 

Senator Dodd. Thank you very much, Mr. Chairman. 

Senator Domenici. 

OPENING STATEMENT OF SENATOR PETE V. DOMENICI 

Senator Domenici. Mr. Chairman, fellow Senators, I would have 
made a lengthy statement and evaluate the situation, but I'm not 
going to do that. I'll put a statement in the record and I'll just 
make a few remarks. 

I want to thank you, Mr. Chairman, for calling this hearing. I 
think this is a hearing in the best tradition of legislating. 

I don't think anyone can deny that there's a problem. The Su- 
preme Court early on recognized that litigation under rule 10(b)(5) 
presents a danger of vexatiousness different in degree and kind 
from that which accompanies litigation in general. Unfortunately, 
the Supreme Court prophesied too well the potential for abuse. 



Former SEC chairman Richard Breeden has noted that, and I 
quote: 

The problem of meritless securities litigation is a serious one, and that such litiga- 
tion imposes costs on the defendant which are ultimately borne by the issuers and 
shareholders. 

He concluded that legislative reforms to deter meritless claims 
would be highly beneficial. He also commented that the current 
system fails to distinguish strong claims from weak or meritless 
claims. 

These hearings are indeed to explore in detail how this section 
of the law is working. I am not sure that real perpetrators, Mr. 
Chairman, of fraud are being penalized enough. Our system should 
penalize them both civilly and criminally to the maximum extent 
possible. 

But equally, I am not sure that merit matters any more and I 
am not sure that plaintiff investors are being appropriately com- 
pensated. I believe we'll hear some evidence about that. 

This hearing has a narrow but important focus. We're going to 
hear from witnesses that know first-hand how rule 10(b)(5) law- 
suits can be filed within weeks, sometimes days, or even in hours 
after a stock drops in price. 

The companies are being hurt. Joint and several liability threat- 
ens accountants, as you've indicated. Since our first panel is CEO's 
from some of the country's highest tech companies, let me talk 
about their part of the problem first. 

I am delighted that each of you has agreed to testify, and I say 
that in all sincerity. I gather it is not so easy to do this for some 
of you. Some of you, in fact, at least one that I know of, are in the 
midst of litigation right now. Nonetheless, you're here. 

Tom Dunlap is here. He is general counsel for Intel. I happen to 
know a great deal about Intel because they have a presence in my 
State of New Mexico. I'm very proud that they are there. They've 
been involved in seven of these lawsuits, as I understand it, each 
triggered when the stock dropped in price. 

I don't want to take your testimony and present it here, Mr. 
Dunlap, for you will do that. But I'm pleased that justice was done 
when the first set of these cases was withdrawn. That was good 
news. 

The bad news is that it took more than 6 months and the ex- 
penditures of substantial resources and legal fees to convince the 
plaintiffs they had no case. 

You won't believe circumstances giving rise to the second round 
of cases, except to say that the case was filed when Intel failed to 
correctly read the mind of another judge. I'll let Mr. Dunlap tell 
you about that. It sounds rather incredulous, but it happens to be 
true. 

According to Scott McNeally, president of Sun Microsystems, his 
company has been sued several times, once when the stock went 
down, once when it went up, and once for settling one of the pre- 
vious suits — a derivative suit. 

The basis of this last lawsuit was that the company settled when 
it shouldn't have settled. 



-\ 



It seems to me that common sense tells us we've got a problem. 
I don't have the answers, but clearly, Mr. Chairman, I believe we 
all are Americans and we all have interests. 

Obviously, we have a compelling interest to see that justice is 
served, that people aren't defrauded. We also have a broad interest 
to see that American companies who are going to hire our people 
and bring technology on board and produce economic prosperity get 
a fair shake out of the system, too. And somewhere, the balance 
has to strike. 

You stated it more succinctly than I. I don't believe that this is 
an issue of lawyers against the Congress or the Congress against 
lawyers. I think this is a situation that cries out for some legisla- 
tive reforms. 

I know for some this is hard medicine because, obviously, there 
are a number of law firms that specialize in 10(b)(5) class-action 
suits. They make a case for their cause. 

Frankly, that's the way things happen in America all the time. 
The fact that legislation doesn't work perfectly and there's a place 
for litigation happens all the time. 

Everyone should know that sooner or later, when the way a cer- 
tain law is malfunctioning gets bad enough, when it gets to a point 
where it isn't doing what people think is good, changes occur. 

Frankly, change is going to occur. I don't know the lawyers in- 
volved with the firms that I read about. I hope that I get to know 
some of you personally here. The truth of the matter is things like 
this have to change. And yet, we have to leave open ample oppor- 
tunity for lawsuits, ample opportunity for merit-filled suits to be 
litigated to the full extent of the law. 

We also have to explore carefully, Mr. Chairman, why so much 
of the settlement fund goes to plaintiffs' lawyers. Why it costs so 
much of the plaintiff investors' proceeds to get these kinds of law- 
suits to conclusion. 

When you have people talking about 30, 40, 50 percent of the set- 
tlement, and they're almost all settlements, going for lawyers' fees, 
you've got to seriously examine whether there isn't a better way to 
protect investors. 

I thank you very much and I ask that my detailed remarks be 
made a part of the record. 

Senator Dodd. Without objection, so ordered. 

Senator Shelby. 

OPENING STATEMENT OF SENATOR RICHARD C. SHELBY 

Senator Shelby. Thank you, Mr. Chairman. 

Mr. Chairman, first, I want to commend you, as others have, for 
calling this hearing. Private actions under section 10(b) of the Se- 
curities Exchange Act serve two important purposes. These actions 
are the primary means through which defrauded investors can seek 
redress. The threat of a suit discourages would-be violators from 
committing fraud. 

This system in which securities fraud is primarily punished 
through private litigation, is not perfect, as we know. There are 
frivolous lawsuits. Publicly traded companies must defend them- 
selves against costly securities fraud actions, often settling to avoid 



expensive, protracted actions instigated by attorneys paid by the 
hour on behalf of professional plaintiffs. 

Companies with volatile share prices are particularly vulnerable. 
This means that start-up in high-tech firms are more likely to be 
exposed to costly securities litigation. These are the same firms, 
however, that provide job growth and contribute significantly to 
U.S. competitiveness. 

I read the testimony of the witnesses. I don't think there's any- 
one in this room that would disagree that the scenarios depicted 
by Mr. McCracken of Silicon Graphics or Mr. Dunlap of Intel are 
wrong. These companies spend at least $1 million to defend against 
meritless securities suits, money that could have been better spent 
invested in R&D or toward employee salaries. 

However, it's not just the issuer of the stock that bears the risk 
in these suits, but also peripheral defendants such as accountants. 
Under joint and several liability, as has been mentioned here, ac- 
countants may be liable for a disproportionate share of damages 
compared to their actual culpability. As defendants with deep pock- 
ets, accounting firms may sometimes be held liable for more than 
their fair share of the damages. 

I recognize that these are significant problems that this commit- 
tee should give some consideration to improving. However, on the 
other hand, it is the testimony of Mr. Ramser, an investor in a 
group of nursing homes, and the testimony of Mr. and Mrs. Billipp, 
that tells exactly my concerns over the solution to frivolous securi- 
ties litigation that have been offered to date. 

Section 10(b) actions are the primary means of policing against 
securities fraud. Changing the system in ways that expose de- 
frauded investors to additional risk is not a satisfactory solution, 
in my view. I believe we must have sufficient checks in the system 
to act as deterrents to those who would take advantage of 
unsuspecting investors. 

Perhaps today's testimony and question and answer period will 
shed some light on what can be done here to eliminate or to reduce 
meritless securities litigation, at the same time protecting the 
rights of the victims of fraud that we all want to do. 

Mr. Chairman, I might have to go soon to another hearing and 
I wondered if you would hold the record open for some written 
questions to be propounded in case we don't get a chance to ask 
them ourselves. 

Senator Dodd. We'll be glad to do that. 

Senator Faircloth. 

OPENING COMMENT BY SENATOR LAUCH FAIRCLOTH 

Senator Faircloth. I'll yield to Senator D'Amato. 

Senator Dodd. Well, we can't do that. We appreciate your effort, 
though. 

[Laughter.] 

Senator Domenici. Then he'll take his time. If he can't get to 
yield, why doesn't he get to speak? 

Senator Dodd. Senator Bryan. 



8 

OPENING COMMENTS BY SENATOR RICHARD H. BRYAN 

Senator Bryan. Mr. Chairman, I have no opening statement. I 
would compliment you for convening this hearing and arranging for 
an impressive array of witnesses to testify before us. 

It is an issue in which we have to balance the rights of those who 
are legitimately aggrieved and to make sure that whatever changes 
are made do not preclude access to the courts for them, at the same 
time to be concerned about any aspect of our system that imposes 
undue and unreasonable restraints in terms of developing the kind 
of capital that we all need to create new jobs and economic growth, 
something which, as every Member of the Congress knows, we fo- 
cused a great bit of time on in the last 6 weeks. 

So I look forward to hearing each of the witnesses and again, 
congratulate you for convening this impressive panel of witnesses. 

Senator Dodd. Thank you very much. 

Senator D'Amato. 

OPENING STATEMENT OF SENATOR ALFONSE M. D'AMATO 

Senator D'Amato. Mr. Chairman, let me commend you and Sen- 
ator Domenici for bringing about these hearings and for your time 
and patience in this. 

Indeed, we're fortunate to have the distinguished witnesses share 
their views on this important subject. 

I want to extend a special welcome to Bill McLucas, the SEC's 
Director of Enforcement. Bill is the top cop on Wall Street and does 
a great job making sure our securities markets remain a safe place 
for investors. 

As Bill McLucas points out in his testimony, the Federal securi- 
ties law provide important protections for investors that are essen- 
tial to maintaining the integrity and fairness of our capital mar- 
kets. 

Many of today's witnesses have found that the laws intended to 
shield investors can be used by some unscrupulous lawyers as a 
sword to extract a settlement in frivolous litigation. 

I'm deeply concerned, as I know other Members of this committee 
are, about the effect of frivolous litigation on our Nation's economy. 
Companies can be forced to spend millions of dollars fighting frivo- 
lous cases instead of hiring new workers, buying new equipment, 
and investing in research and development. Managers can end up 
spending more time fighting lawyers than fighting the competition. 

Abuse of the litigation system has got to stop. While we must 
leave the courthouse door open to let legitimate victims of securi- 
ties fraud in, it's important that judges throw frivolous cases and 
unscrupulous lawyers out. Under the existing rules, judges have 
the ability not only to throw out meritless cases, but to impose 
sanctions on lawyers and parties that abuse the system. 

Judges also have the responsibility under current rules to make 
sure that both the amount recovered by shareholders in a settle- 
ment and the fees paid to their lawyers are fair. If the judges are 
not using the weapons available to combat frivolous lawsuits, we 
need to find out why. 

If these weapons are not sufficient to detect and deter abuses, we 
need to know what can we do. 



Mr. Chairman, I hope that the witnesses will help answer these 
questions and with their assistance and insight, perhaps Congress 
can find a way to settle this matter. 

Senator Dodd. Thank you very much. 

Senator Bennett. 

OPENING STATEMENT OF SENATOR ROBERT F. BENNETT 

Senator Bennett. Thank you, Mr. Chairman. I appreciate your 
convening the hearing and the subject. 

I would share with you and the committee an anecdote, you talk 
about anecdotal evidence, that involves a former Member of the 
committee, my father. 

After he left the Senate, being a young man of 75, and anxious 
to continue a productive career elsewhere, he joined the board of 
a mutual fund. Like many mutual funds, it was technically a series 
of funds. There were 40 or 50 different corporations. 

He was served with a subpoena of a lawsuit. And he said, what 
is this? And the general counsel of the mutual fund said to him, 
well, Senator, because your name alphabetically heads the list of 
directors, they're suing you first and the rest will come later. This 
happens every time there is a cost-of-living adjustment in directors' 
fees. 

There is a law firm in New York that automatically pushes the 
button on its word processor, kicks out the complaint, and sues 
that the directors are enriching themselves improperly at the ex- 
pense of the holders of the securities. They know that the cost of 
defending the suit is going to be about $150,000 in legal fees and 
they're standing ready to settle the suit for $100,000, which we al- 
ways do. 

So every 2 years, we send a check for $100,000 to this law firm 
and they leave us alone. And every time it happens, the director 
whose alphabetical name leads the list is the one who gets filed on. 
So, since Bennett comes before any other name in the group, you 
just prepare yourself for this. It's going to happen every 2 years. 
And it did. 

Senator Dodd. You should have hired somebody by the name of 
Abbott. 

[Laughter.] 

Senator Bennett. They did. 

[Laughter.] 

As a matter of fact, they did, and dad was delighted that he 
wasn't sued any more because it was filed. 

Now the interesting thing about it is that everybody knew there 
was no merit whatsoever in the lawsuit. The law firm had carefully 
calculated what it would cost the mutual fund to defend the law- 
suit and it was prepared to settle for roughly 75 percent of the liti- 
gation cost. And the firm said, we hate it, but from the standpoint 
of protecting the assets, it makes more sense for us to send them 
the $100,000 every 2 years than it does to fight it. 

Interestingly enough, the law firm earned its living doing this 
with mutual funds across the country. That's why they had it on 
their word processor. Every time a mutual fund would adjust its 
directors' fees, it would file the automatic suit. 



10 

It's no longer being done. Why? Because Merrill Lynch decided 
they would fight it. It cost Merrill Lynch $1 million in legal fees, 
but they shut the law firm down, taking them to court and ulti- 
mately embarrassing them and defeating them. 

But that's a pretty high price, to ask Merrill Lynch or anybody 
else to spend that kind of money shutting down this kind of scam. 
And that's the only word I can find to describe it. 

So, as I sit here and listen to the opening statements and thumb 
through the testimony, I can add that one anecdotal piece of evi- 
dence from someone who has sat in these same chairs and dealt 
with these same issues. He's now really retired at 95, but I'll be 
glad to report to him what we finally do nere. 

Thank you, Mr. Chairman. 

Senator Dodd. Thank you very much, Senator Bennett. 

Well, let me welcome our witnesses and thank you for being here 
this morning and participating in this discussion. We'll begin to in- 
troduce them. 

Mr. Edward McCracken, who is the president and chief executive 
officer of Silicon Graphics, Inc., from Mountain View, CA. We wel- 
come you very much, Mr. McCracken. 

Mr. John Adler is president and chief executive officer of — how 
do you pronounce that? 

Mr. Adler. Adaptec. 

Senator Dodd. Adaptec, from Milpitas, CA. He'll be testifying on 
behalf of the American Business Conference. 

Mr. Richard Egan is president of EMC Corporation, from 
Hopkinton, MA. 

And Mr. Thomas Dunlap, who Senator Domenici has already ref- 
erenced, is the general counsel of Intel Corporation, from Santa 
Clara, CA. 

I'm going to ask this panel and the two that follow, we're going 
to take every bit of material, supporting documents and evidence 
that you want to have as a part of this record, and that will be true 
of every panel, so 111 say it once. I'm going to ask you to keep an 
eye on this clock here. I m not going to hold you to this thing reli- 
giously, but just as a good barometer. 

Your full statements will be a part of the record. But if you could 
try and get to the essence of your remarks as quickly as possible, 
then I think the more valuable part of these hearings are the dis- 
cussion that follows and some of the questions, with all due respect 
to your testimony. 

We're going to run that for about 5 or 6 minutes, that clock, and 
then use that as an indication that you should sort of wrap up so 
we can move on and make sure we get everybody's testimony in 
and then get to the questions. 

So, again, we thank you for being here. Mr. McCracken, we'll 
begin with you, and I'll ask you to each testify in the order that 
I've introduced you. 

STATEMENT OF EDWARD R. McCRACKEN, PRESIDENT AND 
CHIEF EXECUTIVE OFFICER, SILICON GRAPHICS, INC., 
MOUNTAIN VIEW, CA 

Mr. McCracken. Mr. Chairman, Members of the committee, I'm 
Ed McCracken, president and chief executive officer of Silicon 



11 

Graphics. I'm pleased to be here today to present my views on this 
very important subject. 

First of all, Silicon Graphics. Who are we? We're an 11-year-old 
company. Many consider us to be the leaders in visual computing. 
Today, there are hundreds of uses for visual computing. Ford, for 
example, uses our computers to design cars. Many of the pharma- 
ceutical companies, including Chiron, use our computers to design 
new molecules for new drugs, such as to cure diseases such as 
AIDS. And computer graphics artists indeed use our systems to do 
motion pictures like the recently released "Jurassic Park." 

In fact, before I left from California, we had a company meeting 
where we passed out T-shirts to all of our employees, entitled, "Sili- 
con Graphics — Making a Better Dinosaur." 

[Laughter.] 

Most recently, we were selected by Time-Warner Cable to de- 
velop technology for a full-service interactive digital TV network in 
Orlando, Florida. It's a new television system that will expand the 
entertainment choices available to people, providing them with a 
host of new services, including educational resources, interactive 
video games, and business services. 

Earner this year President Clinton and Vice President Gore vis- 
ited our headquarters in Mountain View, CA, to release their posi- 
tion papers on the administration's high-technology policy. So it's 
been an interesting time for us recently. 

We're 11 years old — if I could have chart 1. We now have sales 
of just over $1 billion a year. So we've had a nice revenue growth 
period. And in fact, also we've been able to add to our company a 
fairly large number of employees and our current employment is 
approximately 3,600 people, up from nothing 11 years ago. 

During this time period, which is the time period since we went 
public in the late 1986 time period, we've grown from about 400 
people to around 3,600 people, adding high technology jobs to our 
economy. 

About half of our sales are outside the United States. We're a 
major exporter and most of our manufacturing is done in the Unit- 
ed States. We're a heavy believer in having manufacturing right 
next to our research and development centers. 

Fortune magazine has listed us for the last 2 years as one of 
America's 100 fastest-growing companies. 

People in our company are motivated by pursuing interesting 
and challenging ideas. They understand that the pace of techno- 
logical advancement now can be harnessed to achieve a ten-fold im- 
provement in computers' performance every 3V2 years, and they're 
excited about the resulting transformation in our industry. They 
adapt very readily to change and they learned how to incorporate 
it in their daily lives. 

I could talk at length about our company and our scientific and 
engineering and creative successes. And also, the effort of our com- 
pany to become a standard in business conduct world-wide and our 
success in expanding employment. 

However, I'd like to spend more time on the issue in front of us, 
which I think is one of the primary problems in our industry, and 
that's the securities class-action lawsuit. 



12 

Even though companies like Silicon Graphics are successful, as 
you can see from chart 2, there's a constant threat of a securities 
class-action lawsuit. Because stock price volatility goes hand-in- 
hand with risk-taking, innovative companies become targets of 
these abusive suits. 

When the courts first authorized the use of the class-action tech- 
nique in connection with these suits, there's no doubt that it was 
done to ferret out real fraud and real wrong-doing. However, I be- 
lieve that the current practice of off-the-shelf legal complaints 
when a company announces a downturn in performance, essentially 
amounts to an uncontrolled tax on innovation. 

Under today's system, companies can be exposed to potential liti- 
gation whenever the stock price falls by approximately 10 percent, 
even if there's absolutely no violation of security laws or fiduciary 
responsibility. I'd like to tell you about an experience that we had 
in that regard. If I could have chart 3. 

As you can see, our stock price — I put the stock price of Silicon 
Graphics, the top bar on this chart, as an overlay here. The bottom 
bar is the S&P 500. As you can see, our stock price has been rel- 
atively volatile, much more volatile than our revenue or the in- 
crease in employees in our company. 

On April 3, 1991, we announced that the revenues for the quar- 
ter ended March 30, 1991, would be lower than the previous quar- 
ter. This was the company's first revenue decline after six consecu- 
tive quarters of growth. Now the principal reason for the decline 
was Desert Storm. We sell a lot of systems to various Government 
agencies and Desert Storm was a factor in terms of our sales dur- 
ing the quarter. After the announcement, the company's stock 
dropped 10 percent. 

Senator Dodd. Would you explain that? I'm sorry. Why was 
Desert Storm a factor? 

Mr. McCracken. Well, I think there were two reasons. One is 
we do sell a lot to defense agencies and other companies who sell 
to the Defense Department. The Defense Department was pretty 
busy during that time and their normal procurement process 
turned out to be a lot slower because of their activity. 

Also I think there were just a lot of us, including myself, watch- 
ing television every evening rather than working. I know — I had a 
brother-in-law in the 82nd Airborne. I think there was just a lot 
less business done by American business during that quarter, and 
that did impact our business. 

Our stock dropped 10 percent. Several weeks later, I was sued. 
I was personally named as a defendant, along with a few others. 
It was our first suit of this kind. It was a surprise to us. 

We reviewed all of our records. We invested a lot in legal fees. 
We then filed a motion to dismiss the case, which was granted by 
the court. As is typical, however, the plaintiff was given the oppor- 
tunity to refile her case. Then, having examined her new pleading, 
we had to file a second motion to dismiss and also challenge the 
standing of the named plaintiff, the 18-year-old daughter of the at- 
torney's stockbroker, as an adequate class representative. The 
plaintiff held 200 shares of our stock, actually had a straddle strat- 
egy, including call options, as well as purchase of shares. She actu- 



13 

ally made money on the entire transaction. But during this period 
of time, the stock dropped from $42 to $38. 

The plaintiffs' attorneys refused to drop the case without a pay- 
ment. After a lot of internal debate — we wanted to fight this all the 
way — but after a lot of internal debate, we made a decision to go 
back to our business and make a settlement. It was less expensive 
to do this. So this completely meritless case finally was dismissed 
this month after 2 years with well over $500,000 spent to defend. 

Now $500,000 to our company, at $1 billion, isn't all that much. 
But I also represent the American Entrepreneurs for Economic 
Growth, an organization of 6,600 companies with 750,000 employ- 
ees, of which I^n co-chairman. 

I remember 5 years ago, $500,000 would have been a lot of 
money, and it would have also locked us out of the capital market 
during that 2-year period of time and put our entire company in 
jeopardy. So I also represent the even smaller companies. 

But the real cost to the company was much more than that. We 
were distracted. We were distracted, not only myself and the execu- 
tive team, but probably 200 people in our company. 

We curtailed our R&D spending by spending money on legal fees 
rather than research and development ana reinventing ourself 
every year or two — which is our primary method of doing business. 
And finally, our integrity as a company was "put into play." 

I believe that the very threat of these lawsuits in which it is 
business as usual to accuse someone of fraud carries a further on- 
going cost, and that's why I call it a tax on innovation. 

We need to eliminate the incentives from the current system to 
file frivolous cases. Once these cases are put into motion, they're 
almost impossible to stop without some cost to the innocent com- 
pany. 

But, from the plaintiffs' attorney's point of view, why shouldn't 
the case be filed? It's cheap. It doesn't cost anything. Simply put, 
accusing companies and individuals of fraud has virtually no down- 
side and provides a lucrative career for those attorneys which pur- 
sue it. 

If high-technology companies are to be competitive in the global 
marketplace, the management teams must be encouraged to focus 
on innovation, to focus on revenue and job creation and taking risk, 
which produces a volatile stock price. 

It's counterproductive to have just a few attorneys, and I re- 
peat—just a few attorneys — so easily translate this volatility into 
accusations of fraud. 

There are solutions to the problem. I think the solutions are 
quite easy. 

If we fail to address this problem, the incentive to innovate will 
continue to be compromised. On the other hand, if we align as 
many of our systems as possible so that American companies can 
maintain and sharpen their competitive edge, we will strengthen 
our world-wide technology and business leadership and we'll con- 
tinue to provide really exciting and rewarding employment for peo- 
ple in America. 

Thank you. 

Senator Dodd. Thank you very much, Mr. McCracken. 

Mr. Adler. You've got to pull that microphone closer to you. 



14 

STATEMENT OF JOHN G. ADLER, PRESIDENT AND CHIEF 
EXECUTIVE OFFICER, ADAPTEC, INC., MILPITAS, CA 

Mr. Adler. Can you hear me? 

Senator Dodd. Yes, we can. 

Mr. Adler. Good. We've got some charts coming. 

Mr. Chairman, Senators, thank you for having me. My name is 
John Adler. I'm chairman and chief executive officer of Adaptec, 
Inc., located in Milpitas, CA, near Silicon Valley. 

Our company is about 12 years old. It was started in a garage. 
Today, it has $311 million in revenue and 1,400 employees world- 
wide. 

I myself came to this country in 1956 from Hungary, alone, with- 
out a penny to my name and without the ability to speak English. 
I came running from a repressive regime because I believed in free- 
dom and justice. And I'm here today to talk about the justice part 
of it. 

I am representing ABC Member Companies, as well as this list- 
ing of 47 high-technology companies from around the country. For 
the record, there are six additional ones to be added, which are M- 
dol, MediaVision, National Semi-conductor, Selectron, the Malcolm 
Baldrige Award-Winning Company last year, Silicon Graphics, 
which nas Mr. McCracken sitting here, Cisco and Western Digital. 

Some of these companies are private, some are public. I believe 
the largest one is Intel, with over $6 billion in revenue. The small- 
est one is Logical Systems. They employ 25 employees and have 
$2V2 million in revenues. 

The companies are represented from around the country, not just 
from Silicon Valley — Distributed Processing from Florida, ExeDite 
in Colorado, Cyrix in Texas, ALR in Southern California. Some of 
the others are in Northern California, the Silicon Valley area. 

On the left-hand side, the companies without the six additions 
that I mentioned, represent $23 billion of revenue and 135,000 peo- 
ple employed. These are the ABC Companies represented below. 

So I'm speaking on behalf of nearly 585,000 employee companies, 
with revenues of $65 billion, again, excluding the six companies 
that I indicated before. 

When the word got out that I was going to testify, I received sev- 
eral calls advising me not to, pointing out the potential adverse ef- 
fect on my company since we're currently under litigation. This 
would potentially prolong the case, make potential settlements at 
higher cost than otherwise, and make the discovery process more 
arduous. 

You're all familiar with the lawsuits, the basics of these lawsuits. 
The price of the stock drops on some unforeseen, but not ordinary 
business event. 

For instance, the company lost a contract. We didn't know that 
we were going to lose it. A competitor won it. Because of the high 
technology nature of our product, a new product's introduction is 
delayed by a quarter. Revenues are therefore delayed for a quarter, 
so, therefore, revenues are not where they ought to be. And there 
are countless other examples of these which we believe constitute 
normal business events which companies face in the ordinary 
course of business every day. In fact, that's what we get paid for. 



15 

The minimal cost of $120 filing fee is what it takes to file these 
lawsuits, which are all-encompassing. Here's the one [indicating], 
that's against ours. It was produced 4 days after the price of the 
stock dropped at a cost of $120, alleging every wrong-doing under 
the sun without any specificity to anything. 

It alleges that the company has the broadest fishing expedition. 
It claims that management knew or should have known — these are 
horrendous phrases, Senators — have known or should have known. 
Clairvoyancy is what is required today to potentially avoid these 
suits. 

The specifics of the case is fairly simple. Our company has had 
35 consecutive quarter profitability. The company has never lost 
money since it went profitable. In one quarter out of those 35, it 
was the 23rd quarter of profitability, we had a 15-percent revenue 
shortfall, precisely the same quarter that Ed did. We saw a slowing 
of economic activity from the Gulf War world-wide. Within 4 days, 
we got sued. 

The suit alleged everything, firom us violating generally accepted 
accounting principles to artificially inflating Adaptec's revenues 
earnings as assets. It claimed that the viability of the company was 
in danger, so on and so forth. 

During that quarter, which was profitable, even though a little 
lower than we wanted it, the company continued to grow profitably 
ever since. The value of our stock now is currently approximately 
five times what it was when the suit was filed. And we have more 
than doubled in size. Currently, we have 140 openings to hire peo- 
ple to add to the staff. 

So if a company like Adaptec, with 35 consecutive quarters of 
profitability, can be sued for not serving its shareholders, there's a 
problem. 

We received discovery demands containing 105 broad requests, 
including such items as all documentation that refers to sales or 
orders in general and all documents that discuss or refer to profit 
margins at Adaptec. 

We produced over 1,500 boxes of paper, Senator, at a cost of al- 
most $1V2 million. In addition to that, they served subpoenas on 
ten of our major customers and suppliers, without our knowledge, 
and we have to go to court to stop them from doing that. With the 
unlimited discovery potential that the broadness of the suit carries 
with it, we have a national problem. 

Today, we've spent $2 million and we haven't proceeded to depo- 
sition stage yet. As Ed mentioned, we could have hired engineers 
because we diverted money from the R&D budget, introduced new 
products, hired more sales marketing and manufacturing people, 
created jobs for our supplier 

Senator Dodd. Keep an eye on that clock now, Mr. Adler. 

Mr. Adler. Pardon me? 

Senator Dodd. Just keep an eye on the clock there. 

Mr. Adler. I'm sorry. I'll be done in 30 seconds, sir. 

When you multiply the effect that we experienced by the unbe- 
lievable number of companies being sued, it is clear that we have 
a national problem. 



16 

Another problem is I have difficulty attracting people to serve on 
my board. The public company, at a time when you all want to in- 
crease corporate governance over schlocky CEO's like myself 

[Laughter.] 

And my greatest frustration is that these suits have a life of 
their own. F can't get rid of them. I can either settle or go on for 
2 or 3 more years until it gets to court. This needs a legislative 
change, in my opinion, because this is fully in line with the stated 
objective of trie administration; that is, to create more jobs, make 
American business more competitive, and increase corporate gov- 
ernance of companies. I think this change should have support on 
both sides of the aisle. 

Thank you. 

Senator Dodd. Thank you very much. Mr. Egan. 

STATEMENT OF RICHARD J. EGAN, CHAIRMAN, EMC 
CORPORATION, HOPKINTON, MA 

Mr. Egan. Mr. Chairman and Members of the subcommittee, I 
thank you for this opportunity to express my views and deep con- 
cerns about the devastating and debilitating effects of meritless se- 
curities fraud lawsuits on publicly-traded companies, particularly 
those in high-technology. 

My name is Richard Egan. I'm chairman of the board, founder 
and director of EMC Corporation in Hopkinton, MA. We design, de- 
velop and manufacture high-performance computer storage sys- 
tems. We employ approximately 1,600 people and operate 60 field 
offices arouna the world. Revenues last year were $349 million, of 
which about 30 percent was derived outside North America. 

Like so many high-technology companies, EMC started small and 
with limited finances. My co-founder and I pooled our savings and 
extended our credit card limits to the maximum to fund EMC's 
start-up in 1978. Thanks to a lot of hard work and a lot of luck, 
we grew at a rapid rate, such that by 1986, we had to turn to the 
capital markets for equity. 

Since becoming a public company, we've been the target of two 
lawsuits that I call strike suits, because I have since learned they 
are typically filed within days or sometimes hours of a company's 
announcement of adverse news and disappointing earnings. They 
are intended to coerce companies into settlement. 

The first lawsuit, which was filed in 1988, was initiated by a law 
firm on behalf of a fellow who I later learned was a professional 
investor and a partner in a money management firm. 

This lawsuit was prompted by an announcement that our quar- 
terly earnings would be lower than they were the previous quarter. 
The reason for that was the cost of semiconductors escalated in 
that period of time due to the Government's intervention in terms 
of setting price limits on dumping. 

Our legal counsel advised us that our management had not acted 
in any improper or illegal manner, but it would be very expensive 
to defend ourselves. Because we were still a small company and be- 
cause we could have been completely wiped out by an adverse court 
ruling, I decided very reluctantly to pay him off. 

As a result of this strike suit, management decided that we 
would in the future limit public information about EMC and its 



17 

progress and expectations. Most class-action suits are usually filed 
after a public announcement by the company and the plaintiffs' 
lawyers race each other to the courthouse to De the first to file a 
suit. 

Obviously, since these suits are filed so quickly, there is no time 
for any factual investigation about whether fraud was actually 
committed. Instead, once the suit is filed, the plaintiffs' law firm 
proceeds to search through all of the company's documents and 
take endless depositions with the slightest positive comment which 
they can claim induced the plaintiff to invest, and any shred of evi- 
dence that they thought indicated the company knew a downturn 
was coming. 

Although the SEC continues to encourage public company's from 
actual disclosure, these strike suits have exactly the opposite effect. 
Now we always have a defensive posture in our statements because 
of concern that we will be sued. In addition, companies can become 
more reluctant to take business risks, for each time a risk fails, we 
are subject to a suit for fraud. 

A second strike suit was filed against EMC in 1991. It followed 
only 20 hours, less than one business day after our public an- 
nouncement that quarterly results, which had been increasing 
steadily, would show less profitability than the prior quarter. We 
were not reporting a loss, only a decline in earnings. 

Bv the time the second strike suit was filed, we were big enough 
to defend ourselves and we still remembered how outraged I was 
when the first suit was filed. We were fortunate in that we argued 
before a very sophisticated and intelligent judge that took the time 
to understand the case and saw through this charade. 

A copy of the court's decision in this case will be submitted for 
the record to the subcommittee, but, in brief, in March, 1992, the 
Federal judge dismissed the lawsuit with prejudice and chastised 
the plaintiffs because they, in the judge's words, apparently wished 
to embark on a fishing expedition at tne defendants expense. 

Nevertheless, EMC management and its attorneys spent an enor- 
mous amount of time in defending this thoroughly meritless law- 
suit. Needless to say, the distracted management time cost us sales 
and planning for the future. 

Mr. Chairman, I have since learned that such fishing expeditions 
are not uncommon. Apparently, there are a number of law firms 
that specialize in filing claims against high-tech companies such as 
EMC that often have unpredictable results. 

Usually, these law firms rely upon a cadre of professional plain- 
tiffs that own only a few shares of many public companies and who 
are solicited by the law firms when a plaintiff is needed. 

I understand that one individual, a retired attorney, has been 
the plaintiff in over 300 lawsuits. The lead plaintiff in a class-ac- 
tion suit can be awarded a substantial bonus just for lending their 
name to the complaint. The plaintiffs in our case were two persons 
who collectively owned a minimum amount of stock. Once the suit 
is filed, they are practically guaranteed a windfall of legal fees 
since virtually all lawsuits are settled with the company's paying 
the attorneys fees. 

I think there are a number of things that will happen if these 
are not curtailed. 



18 

Companies will be reluctant to publish forecasts, despite the 
SEC's and investors' requests to do otherwise. Companies will not 
take sound risks, but will manage their operations so as to main- 
tain steady performance and avoid stock fluctuations. 

The corporate decision-making process will be severely hampered 
by the need to scrutinize every action that might possibly be the 
subject of a lawsuit. 

Companies will pay enormous sums to law firms and not their 
investors. Management time will be diverted to defend these law- 
suits. U.S. corporations will remain at a disadvantage because we 
must constantly think short-term in order to deliver acceptable fi- 
nancial results every 90 days, rather than focusing on long-term 
development, a disadvantage with which most of our foreign com- 
petitors do not have to contend. 

Mr. Chairman, I firmly believe American industry must be effi- 
cient and productive and there are some steps that Congress 
should do to alleviate this troubling problem. 

First, plaintiffs and plaintiffs' legal counsel should be required to 
pay the legal costs and expenses of defendants in cases which are 
found to be frivolous and unjustified. I know that's a tough one. 

There should be a standard of clear and convincing proof for alle- 
gations of fraud against companies. This would discourage lawsuits 
based on statements by a company that turned out to be inaccurate 
but were not intended to mislead. Plaintiffs should not be invisible. 
They should not be allowed to become professionals, that is, appear 
in lawsuit after lawsuit after lawsuit. 

In addition, contracts arranged between the plaintiffs and their 
law firms should be made discoverable. The American Bar Associa- 
tion should be urged to track and investigate activities of law firms 
that engage in repeated strike suits. 

Before concluding, and it's my last paragraph, I wish to relate to 
you a recent conversation I had with the president of a company 
and a friend that produces computer disk drives. This market is 
very competitive and the companies involved are known to experi- 
ence very volatile sales and earnings. 

My colleague told me that his firm was a defendant in a strike 
suit. It was his third, his fourth, or his fifth. I said, "so what else 
is new?" He replied, "this time they sued me because the stock 
price went up." 

I said, by the way, the law firm that was suing him for the stock 
that was going up was simultaneously suing him for the stock price 
going down. This story might not be so funny if it was not indic- 
ative of the terrible threat to American companies, our economy, 
and our Nation's competitiveness around the world. 

Thank you for your attention and interest and I'll be pleased to 
answer any questions you have. 

Senator Dodd. Thank you very much, Mr. Egan. 

Mr. Dunlap, welcome. 

STATEMENT OF THOMAS DUNLAP, JR., GENERAL COUNSEL, 
INTEL CORPORATION, SANTA CLARA, CA 

Mr. Dunlap. Thank you, Mr. Chairman, and Members of the 
committee. 



19 

Senator Dodd. By the way, we have been joined by Senator Carol 
Moseley-Braun and Senator Patty Murray. 

Do each of you want to make a statement? 

Senator Murray. [Nods in the negative.] 

Senator Moseley-Braun. [Nods in the negative.] 

Senator Dodd. Fine. 

Mr. Dunlap. Mr. Chairman, Members of the subcommittee, I'm 
Tom Dunlap, general counsel of Intel. I'm the only lawyer up here. 
I actually joined Intel 19 years ago as an engineer. So I would ap- 
preciate it if we don't remind my boss that I went to law school. 

[Laughter.] 

We are a high-technology company in the Silicon Valley. We have 
major manufacturing facilities in New Mexico, in Arizona, and Or- 
egon. In fact, the main product that we make are these chips that 
go into the personal computers. You might think of them as the 
brains of the personal computer. In fact, if it wouldn't be for the 
personal computer today, we probably wouldn't be able to have 
these automatic suits. 

[Laughter.] 

The silicon we make allows this to happen, but it also obviously 
provides a lot of other benefits to the country. 

Now, in order to compete in the international marketplace, Intel 
will invest in 1993 approximately $900 million in R&D. A lot of 
that R&D is, by its very nature, speculative. We don't know what 
technology is going to really turn out. When you spend that kind 
of money, some things are going to work, some things aren't going 
to work. The result is that, very often, you can have some short- 
term volatility in high-technology companies. 

Actually, Intel will be celebrating its 25th anniversary this year. 
So we're one of the older high-technology companies. In our first 23 
years, we didn't have any securities lawsuits whatsoever. 

The interesting thing about the last two is that the stock price 
has gone from a low of about $23 V2 in August 1991 to $56 V2, I be- 
lieve I read in the paper this morning. And we've been sued during 
that period seven times. 

Our earnings per share also has gone from 48 cents a share in 
the first quarter of 1991, and in the latest quarter this year, we 
had $1.24. So we've had a significant increase in earnings and in 
fact, the stock price and the result was seven lawsuits. 

Now the seven lawsuits are based on two events and very typical 
of what you've heard so far this morning. The first one was in Sep- 
tember 1991, where we determined internally within Intel and 
then immediately announced to the market, that our revenues and 
earnings would be significantly lower than what Intel or the mar- 
ket in general expected. Within a few days of that announcement, 
the stock had dropped. The stock dropped from $24.88 to $20.75, 
which meets the 10-percent rule. So automatically, we were sued. 

What happened at the time was my boss said, "we're not going 
to pay extortion here. We are going to fight this suit. We have the 
ability to do it and we should simplv fight it to the bitter end." 

But the first thing you have to do is you have to start with dis- 
covery. We had to search for documents. We had to interview a 
large number of our executives. We then had to produce a whole 
bunch of documents to the plaintiffs. So, in short, we directed our 



20 

time and money to litigation instead of to research and develop- 
ment. 

Now what we did is we developed what we call a rule 11 letter, 
which is a letter we send to the other side and say, "here's the in- 
formation, you should have never filed this suit. If you will drop 
this suit now, we'll forget about this. We won't go after you for rule 
11 sanctions. But if we go any further, we absolutely will." 

The plaintiffs thought about it for a while and then they dropped 
the suit. 

In this particular situation, because of the way that it worked 
out, we did not have to pay any settlement. We just had to pay our 
own attorneys' fees. But we did waste a lot of time, management 
time. 

The exact same scenario — not exactly the same, I guess. Slightly 
different, but the same basic algorithm is in April 1993, a judge 
granted a new trial in a case that we had won against one of our 
competitors. 

Here, the stock was at $55. It opened the next day at approxi- 
mately $47V2. Actually, my statement has a typo. It says $50. It's 
$47 V2. It recovered to $48. A few days later, it's at $51V3. It actu- 
ally closed above the price of the stock before the decision came out 
in a matter of a month. 

We did the exact same rule 11 procedure and once again, the 
case was dropped. 

So here's two lawsuits that had no basis. It cost us over 
$500,000, which, granted, Intel can take the time and money to de- 
fend these suits, out that $500,000 could have supported another, 
say, ten production workers. We could have had engineers design- 
ing products. 

I don't know what invention we didn't develop because it's hard 
to measure exactly what these engineers could have created. But 
it's the kind of thing that if it would have happened to Intel in our 
early years, we may not have the microcomputer today. 

We started out making memories. We came up with the idea of 
a microprocessor which has given us a lot of things today like the 
personal computer that we would never have. 

And in fact, the other day I talked to the president of a small 
company like Intel was when I joined 19 years ago. His R&D budg- 
et is only $600,000. He had to pay the same $600,000 to defend his 
securities lawsuit. 

So thank you very much. That's been our experience in these 
kinds of suits and I think that there is something that we can do 
to modify the laws in this particular area. 

Senator Dodd. Thank you very much. Now we'll apply the same 
rule to our colleagues up here, so I'll ask the staff to inform us 
when we've — that clock is on, so we'll give everyone a chance here 
to move around as quickly as we can. Again, thank you for being 
here this morning and sharing your stories with us. 

Several of you, including Mr. Dunlap, have testified about your 
own experiences in cases that were filed against you that were 
later dismissed, whether it was a rule 11 letter or whatever else 
you used, whatever vehicles you used. It was costly, obviously, as 
you pointed out, to go through that process. But they were either 
dropped or dismissed. Some weren't, obviously, refiled and so forth. 



21 

Some would point to your testimony — in fact, I suspect they will 
in later panels — and say, it's working. Granted, you have problems 
here and you're spending money, but the legal system is in effect, 
by and large, rejecting frivolous claims or there are vehicles under 
the law that would allow defendants to respond in a way that has 
discouraged plaintiffs from pursuing those cases further. 

It is annoying. It's painful. It's costly. It does a lot of things and 
it endangers the viability of companies. But the bottom line is in 
many of the examples you cited here this morning, the outcome has 
been in the defendants' favor. 

So I'd ask you to sort of respond to your own testimony, in a 
sense here. I'll begin with you, Mr. Dunlap. If I were going to cross- 
examine you, I'd say, you cited two examples to me. You sent two 
letters to the plaintiffs and the cases disappeared. What are you 
complaining about? 

Mr. Dunlap. Well, it cost the plaintiffs probably $120 to file the 
lawsuit. It cost Intel about $500,000 to write the rule 11 letter to 
make it convincing enough. You're right. In the case of Intel, we 
spent that money. We could afford that money. In the case of a 
smaller high-technology company, they can't afford that. 

Senator Dodd. Do they have to be sued, though, on the basis of 
a decline in stock prices? 

Mr. Dunlap. I'm sorry? 

Senator Dodd. You cited the example of the small company that 
had profits of $600,000, that had a securities action filed against 
it and it cost them $600,000 to defend the suit. Do you recall, what 
was the case in that particular fact situation? 

Mr. Dunlap. The fact situation was very similar to what you've 
heard before, a drop in the stock price and no particular allegations 
of fraud. Just that they met the 10-percent rule. 

Senator Dodd. OK Anyone else like to comment on this? 

Mr. Egan. I would like to comment on it, Senator. 

Senator Dodd. Yes. 

Mr. Egan. It's somewhat analogous to the claims by the plain- 
tiffs' bar that they take up the slack in the surveillance of the SEC. 
I think that's self-serving baloney. Any time we miss the analysts' 
numbers, the stock tanks and we catch heck. Large institutional in- 
vestors bail out. The little ones personally call us up. I've gotten 
lots of calls, principally from small investors — that is, investors 
who have a small number of shares. The press usually amplifies 
the negative results. You get an article this -big when you miss the 
numbers and sometimes you don't even get mentioned if you make 
the numbers. 

Senator Dodd. You'll get some sympathy up here with that kind 
of a complaint. 

[Laughter.] 

Mr. Egan. I guess you understand the press. I'm basically saying 
that we don't need the additional pressure of expensive and divi- 
sive lawsuits. 

The industry, as a whole, we recognize the need for absolute 
legal redress in factual lawsuits. I know it's also difficult to sepa- 
rate the real case from the frivolous. But in retrospect, I think it's 
obvious and there is considerable abuse. 



22 

I'm sure that legislation could be crafted to dissuade these frivo- 
lous suits. 

Senator Dodd. You appreciate our position. We're sympathetic, 
obviously, to the cases where you have professionals who just go 
around and stir up litigation for the sake of it. But we've got to be 
very careful here that as we try and fix that particular situation, 
we don't simultaneously deprive victims of real fraud of a legal 
remedy, which I'm sure none of you want to see because I'm sure 
you know examples as well of competitors or others who engage in 
practices that you find deplorable out there. And to deprive that le- 
gitimate plaintiff from having an opportunity to have some redress 
against those activities and striking that balance here in a free so- 
ciety is the challenge before us. 

Now some will talk about statistics. You talked about examples 
specifically that have happened to you here. And yet, they'll point 
out that the actual number of suits filed has dropped in the last 
20 years in this area. If you look at the broad range, across the 
country, the total number has actually declined and not increased 
numerically. 

Do you nave evidence that would contradict those statistics in 
terms of the volume, because one of the complaints we get is the 
sheer volume has made it difficult for industry and business to 
raise capital and to attract people to serve on boards and the like. 
Can you offer that sort of evidence for us? 

Mr. Adler. I certainly challenge the notion that the number of 
suits have dropped in the last 20 years in the high-tech community 
since the high-tech community has been an engine of jobs that has 
hardly been around for 20 years. 

Second, the rule 11 that Tom Dunlap talked about from Intel is 
rarely used, and although it's unfortunate for me that he used the 
examples that rule 11 is a good tool, my understanding is the sta- 
tistics show that 96 percent of the cases settle for money and never 
get to trial and never get to rule 11. 

Senator Dodd. 96 percent? 

Mr. Adler. Yes. 

Senator Dodd. OK. Let me ask you this. My time is up. And you 
can respond if you want to that last comment I made. 

Are you as companies seeing a similar problem in other areas of 
litigation? For instance, in product liability. You all are producing 
products. Do you face similar problems in that area or are the 
problems that you're facing in terms of legal action exclusively fo- 
cused on this particular area, whereas, product liability problems 
are not as much of a concern? 

Mr. Egan. I think we've seen — I think we've seen at our company 
and other companies increases in patent litigation, where claims of 
patent infringement have been filed. 

They also, like cases revolving around securities suits, take on a 
life of their own and do drain the resources-. So sometimes, I think 
that those could be considered frivolous as well and I think there's 
a lot of those. 

Senator Dodd. Mr. McCracken. 

Mr. McCracken. Senator, in my experience, and also amongst 
the CEO's that I know in Silicon Valley, I think it's very clear that 
this is the number 1 problem in litigation. This is a problem that 



23 

we all know that if our stock price drops, that we will get sued. 
It's out of balance. That's the issue. It's really out of balance. I 
think Tom mentioned that it costs nothing on one side and it costs 
a lot on the other. 

In some ways, it's kind of like receiving a positive poll before an 
election and then losing the election and then getting sued. That's 
exactly the analogy with what we face. If we say anything positive 
about the company and have a negative result, we're going to get 
sued. We all know that. It's the biggest issue we face in the litiga- 
tion arena. 

Senator Dodd. Anyone else want to comment on this particular 
point? How about you, Mr. Dunlap? 

Mr. Dunlap. At Intel, we do have a lot of litigation and we do 
have a reasonable amount of intellectual property litigation on pat- 
ents and so forth. But those cases I think have much more founda- 
tion. Those take time and energy, but it's going to take time and 
energy on both sides. 

You don't file a case either as a patent owner or as a defendant 
and you don't defend it unless you think you really have a reason- 
able basis for the suit. It's the huge disparity between what it costs 
the plaintiff in hundreds of dollars and the hundreds of thousands 
of dollars that it costs the defendant. 

Mr. Adler. We're not here to ask you to erect a wall. We're ask- 
ing you to provide some level of filter that would disallow the fish- 
ing expedition that is started by $120 based on the price of the 
stock drop. 

Senator Dodd. We appreciate that. Senator Domenici. 

Senator Domenici. Thank you, Mr. Chairman. 

Once again, I thank you for testifying. It seems to me that this 
problem is meritless lawsuits, and this is something that the busi- 
ness community is well aware of. There are many discussions about 
it, albeit, anecdotal. There is a lot of evidence being exchanged be- 
tween executives and chairmen of the board and others about 
what's going on. 

Is that a fair statement? You all know what's going on out there. 
So when you say, this is an off-the-shelf $120-lawsuit, what does 
that mean, off-the-shelf? 

Mr. McCracken. What that means, Senator, is that the word 
processing has been done. It's sitting there on the shelf. With the 
computer system that you probably use, you replace one company's 
name with another. Since there's nothing specific about it except 
dates and particular stock prices, the filing can be made right off 
the shelf. It's very cheap. 

Mr. Egan. Let me amplify on that. Our second lawsuit, Senator, 
was filed and the filing had another company's name in it, in many 
cases. 

Senator Domenici. I was going to ask about that because I heard 
that on one occasion, a suit was filed with the wrong company's 
name. I also heard one suit was filed before the stock went public, 
and the suit was withdrawn and then filed again once it went pub- 
lic. Are you aware of that? 

Mr. Egan. I don't know about the latter, but I do know in our 
case, obviously, the claims were vanilla claims that had been filed 
against a previous company. 



24 

Mr. Adler. There was a Wall Street Journal article a year and 
a half ago about these Instamatic cookie-cutter suits where the 
word processor clerk forgot to change in some places the company's 
name. So half the lawsuit referred to one firm and the other part 
of the paperwork referred to another one. 

Senator Domenici. Mr. Dunlap, in your testimony, you make a 
statement that I don't understand. You referred to a 10-percent 
rule. You said, the stock, albeit, over time, did great, there was a 
drop and you said that there was the 10-percent rule and you were 
sued. What's that about? 

Mr. Dunlap. I think that what happens, if the stock drops more 
than 10 percent, irrespective of the reason, without the facts, the 
computer just says, these are the stocks that dropped 10 percent. 
So, therefore, we ought to take the complaint that we have on the 
computer and just bring it up and put the names in. 

Senator Domenici. How do they get the information about the 10 
percent? Where does that come from? 

Mr. Dunlap. Well, unfortunately, we make these chips that 
allow other companies to make powerful computers that can just 
keep this data and just mathematically determine when they drop 
10 percent. That would be pretty easy for a chip. 

Mr. Egan. We think their Quotrons are connected to their word 
processor, Senator. 

[Laughter.] 

Senator Domenici. You think it's that far? Let me ask this ques- 
tion. I'm going to give you a set of facts and ask each of you based 
on your experience to comment. I ask you because you have been 
sued, and you're in the community that's concerned about frivolous 
litigation. In fact, Mr. Adler, you represent a group of companies. 

I'm aware of one company that earned $30 million in revenues. 
They're being sued because their stock price dropped. They suc- 
ceeded in getting a judge to grant the first motion to dismiss. It 
sounds like something iVe just heard. Unfortunately, the case was 
dismissed without prejudice, so it was refiled and the company is 
in the process of filing a second motion to dismiss. 

Because of this pending lawsuit, this company has two vacancies 
on its board of directors that it can't fill. It's having difficulty find- 
ing an auditor. He relayed that high-tech firms like this have a 
one-in-eight chance of being sued over a 3 -year period. There's a 
97-percent chance there will be a settlement payment, so the audi- 
tors are shying away from representing this firm. 

The attorneys' fees so far are more than $500,000, an amount 
equal to one half of their annual R&D budget. 

Now, none of you are in that position. Perhaps this person is not 
here because he is in this position. But would you care to comment 
for the subcommittee on what you think about this set of facts? Is 
this a pervasive set of facts? Is it just pure anecdotal? Or is it a 
familiar worry you share as an American businessman? 

Mr. McCracken. 

Mr. McCracken. We've just added an additional board member 
to our board of directors, Dr. Lucille Shaprio from Stanford Univer- 
sity, a molecular biologist, head of the Department of Developmen- 
tal Biology of the Stanford Medical School. Her number 1 problem 



25 

with considering being on our board, even at our size, was this par- 
ticular class of litigation. 

So, absolutely, in my personal experience, this is an issue. Of 
course, if we were smaller, if we were down to the $30-million size, 
my friends who run $30-million companies in the valley are much 
more at risk. We're in a risk business. We reinvent our companies 
every 18 months. We obsolete our own products to come out with 
new products. It's that chaos in the marketplace in high-technology 
that produces the innovations that allow America to be at the lead. 
This gets in the way. 

Senator Domenici. As an aside, Mr. McCracken, as I understand 
it, President Clinton and Vice President Gore unveiled the adminis- 
tration's major — I think it was a $17-billion program on technology 
initiative at your headquarters of your business there in California. 
Is that correct? 

Mr. McCracken. That's right. In February of this year, they un- 
veiled the technology plan, primarily oriented around the national 
information infrastructure idea, at our facilities. 

Senator Domenici. Mr. Adler, Mr. Egan or Mr. Dunlap, I gave 
you a set of facts based upon what I heard from a smaller com- 
pany. Would you care to comment for the subcommittee on how 
typical you see that in the marketplace out there? 

Mr. Adler. We're a highly profitable company with officers and 
directors liability insurance. I've been fortunate enough recently to 
attract Mr. Phil White, who is the head of Informix, who has just 
recently settled for a $8V2 million class-action lawsuit. 

On our board, I have one additional opening that I have been un- 
able to fill for the concern of litigation. I myself have refused to 
serve on boards. 

Senator Domenici. Mr. Egan. 

Mr. Egan. Senator, I had one director that had been sued. Per- 
sonally named in a strike suit at a previous company. And what 
we did, all I can say is he went nuclear and is no longer with our 
firm. He resigned. 

We don't have liability insurance. In fact, it's my recommenda- 
tion to all companies not to buy liability insurance and to let the 
10 or 12 major strike suit firms know this because the second ques- 
tion — the first question in a deposition is who are you? And the sec- 
ond question is now much insurance do you have? 

Mr. Dunlap. This scenario that you raised is obviously not the 
scenario that Intel deals with at this point in time. But I think 
that's the typical scenario in the bay area that concerns small high- 
technology companies. Again, it's the kind of thing that when we 
were that size, we only made one product. If we would have just 
continued to make that product, we'd be out of business today. 
That particular product line, the foreign competition has put a tre- 
mendous amount of pressure on the Americans and there's very 
few of us left in there. 

So, we needed to come up with a different product line and if we 
have to pay the legal fees, if small companies have to pay those 
legal fees, they're not going to be able to develop the innovation. 

Senator Domenici. Mr. Chairman, I know my time is up. Could 
I ask one more generic question? 

Senator Dodd. Sure. 



26 

Senator Domenici. Let me get again for the record, if we may, 
Mr. McCracken, and each of you. we're talking about a class-action 
procedure predicated upon a substantive statute that talks about 
fraud. 

Now, could you for the record take any of the suits that you were 
in, dismissed or otherwise, settled or otherwise, would you give me 
an example of what happened in the marketplace that caused the 
lawsuit — what I'm trying to find out from the company standpoint, 
what happened that precipitated a fraud suit? 

Mr. McCracken. In our particular case, we, in this particular 
quarter, missed the forecast that the financial analysts had made 
about our revenue by a small factor due to the gulf war and its im- 
pact on our business. Our stock went down 10 percent. It recovered 
quickly thereafter, actually. And we were sued. 

Senator Domenici. Mr. Adler. 

Mr. Adler. We had forecasted 1990 fourth-quarter results to the 
fiscal community. In our business, we usually get 40 percent of our 
revenue in the third month of the quarter. By the first week of De- 
cember, which is the third month, it became clear to us that we 
were not going to make the numbers. 

We called a teleconference and called up the analysts that cover 
the company to a level playing field and an announcement at the 
same time that we were going to have a revenue shortfall of about 
15 percent from what was projected. Four days later, the stock 
went down almost 20 percent or so. It recovered. But while it was 
recovering, we were sued in 4 days. 

Senator Domenici. Mr. Egan. 

Mr. Egan. Just fundamentally, the stock price declined. The rea- 
son for the first one was that the price of our raw materials in- 
creased. The second time, the analyst had forecast us like this be- 
cause that was the slope, and we did that. 

Just disappointed the analysts. That's basically it. Forecasting is 
a very difficult process, particularly when it involves the future, 
Senator. Strike suit attorneys have made it a very punishing proc- 
ess. 

Senator Domenici. You said strike suit. What does that mean, 
a strike suit? 

Mr. Egan. A strike suit is a meritless class-action suit in which 
the attorneys rush to the courthouse without any basis of fact and 
just sue you on the basis that your stock has dropped. Simulta- 
neously, they seek out a plaintiff, usually their associates. 

Senator Domenici. Let s get Mr. Dunlap. 

Mr. Dunlap. The forecast that I missed was in fact reading the 
judge's mind that he was going to grant a new trial after he denied 
it before. The market was very surprised. No one thought it was 

foing to happen. I didn't think it was going to happen. The judge 
id something that surprised the market and that's why the stock 
dropped. 
Senator Dodd. Thank you very much. 
Senator Domenici. Mr. Adler. 

Mr. Adler. Dick Egan talked about the difficulty of forecasting 
the future. We have had 35 consecutive quarters of profitability. 
Thirty-four out of 35 quarters, we forecasted accurately. We missed 
one out of 35, and that was the basis of the suit. 



27 

Senator Domenici. Thank you very much, Mr. Chairman. 
Senator Dodd. Thank you. 
Senator Moseley-Braun. 

OPENING COMMENTS BY SENATOR CAROL MOSELEY-BRAUN 

Senator Moseley-Braun. Thank you very much. 

I was not able to hear all of the testimony, but certainly some 
of it. I've been able to review the information that has been pro- 
vided to the committee. I suppose that my question is really a sim- 
ple one. On the one hand, we have the issue and the problem of 
dealing with uncontrolled litigation, some of which is frivolous, 
some of which, arguably, is not, much of which is not, that you 
once, Mr. McCracken, in your statement referred to as a tax on in- 
novation. And I think most of us would agree that particularly the 
frivolous suit puts a damper on our competitiveness. 

But, on the other hand, we as a committee have the responsibil- 
ity to protect investors, a responsibility to see to it that we don't 
begin to tinker with the system and wind up doing more harm than 
good, that we don't leave investors more susceptible to fraud or 
failure to disclose material information. In that regard, we are 
called upon, as we are often, to be what we used to refer to as the 
CDLS — that's the Committee to Draw the Line Somewhere. 

[Laughter.] 

And so, as we address that, I've been listening. And what I've 
heard is kind of a recitation of experiences and the like. But I sup- 
pose my question would be what specifically are your recommenda- 
tions? Or do you have specific recommendations? 

I looked at, again, Mr. McCracken's statement, and you have as 
a footnote some proposed approaches. But other than, you know, 
the first thing we do, let's kill all the lawyers, what would you sug- 
gest as specific responses that you'd want to put up for us to take 
a look at on behalf of the case that you're making this morning? 

Mr. McCracken. Senator, we did put that footnote in the testi- 
mony. I'm not an attorney. I don't know exactly what rules or 
changes in law should be proposed to change the situation. I do 
know that there's a loophole in the current situation that allows 
frivolous lawsuits in the name of fraud. 

It seems to me like there are several different alternatives for 
change. We would be more than happy to be involved in the proc- 
ess of drafting or proposing ideas for specific situations. But I'm not 
an attorney. I'm responsible for producing innovation in our com- 
pany and producing growth in jods. But I think it is possible and 
I would leave it to others to come up with the specific ideas. 

Mr. Egan. Yes. I mentioned, I thought, four. I think one of them 
is a tough one for you all. But there s one that set a standard of 
clear and convincing — I'm not a lawyer, either, but I think that has 
some specific definitions — proof for allegations of fraud against 
companies. This is to discourage lawsuits based on statements by 
the company that turned out just to be inaccurate. 

The other is to somehow make the plaintiffs, these invisible 
plaintiffs, come forward and to identify these plaintiffs that are re- 
petitively plaintiffs over and over again. And any arrangements be- 
tween these plaintiffs and the plaintiffs' law firms should be dis- 
closed. 



76-761 - 94 - 2 



28 

Those are some of the recommendations. The first one that I had 
made, which is the tough one I referred to, and that is to make the 
plaintiffs' attorneys pay the legal fees of the defendants where it's 
proved to be frivolous. I know that's difficult. I know that's very, 
very difficult. But in these lawsuits, if a class-action suit is deter- 
mined by the judge to be a class-action suit, we the companies have 
to advertise for plaintiffs to join the plaintiffs' law firm. 

Now if that's ridiculous, then having to pay for the other person's 
legal fees in a frivolous lawsuit that happens over and over again 
by the same firms, I don't think is that far out. I'd like you to seri- 
ously consider that part of the legislation, having the plaintiffs' 
firms pay the damage. 

Mr. Adler. Because our experience is with the broadest of all 
conceivable fraud that we have committed, having violated vir- 
tually all generally acceptable accounting principles and so on, we 
would feel some kind of specificity of fraud mentioned rather than 
all-encompassing, which then opens the door for a fishing expedi- 
tion. 

I wouldn't mind a suit that said, we looked at your 10-Q that 
you filed with the SEC and on page 27, you said this and that's 
fraud. And if it is, it should go forward into litigation and trial. 

But based on the fact that a stock price drops 10 percent plus, 
you get the broadest possible allegations and, as Dick said, there 
could not have been any time to see that there is a reasonable 
claim for investigation. It's automatic. The technology we collec- 
tively produce makes this possible. 

So specificity — what did I do wrong? I still don't know what I've 
done wrong and I have a suit filed against us, or officers in the 
firm, and it still doesn't say what I did wrong other than the gross, 
broad allegations. 

Senator Moseley-Braun. Well, certainly, again, I don't know. 
It's difficult for me to sort out whether we're talking about admin- 
istrative changes, changes in the rule, or changes in pleading rules, 
which is what you seem to suggest. 

But on the issue of the frivolous lawsuits, we've got rule 11. I 
was joking, and it's not such a joke and maybe I'm showing my age 
here or something, but years ago, there was a cause of action called 
maintenance in jeopardy that you got when frivolous lawsuits were 
filed. You could always go into court and say, this lawsuit is with- 
out merit and it's filed for other than legitimate reasons, and you 
did have recourse. 

And I have not seen anything, and I've certainly not followed the 
developments in the law closely enough to know what happened to 
all of that. But it seems to me that maybe we don't want to take 
a bazooka to ruin a system that in the main works, but has some 
abusive aspects. I guess my question is whether the difficulty or 
whether in your view, or your lawyer's view, even, the difficulty is 
in part the operation or the administration of litigation in this 
area. 

Mr. Adler. I'd like to mention that because I don't think you 
were here earlier, that Dick is testifying on behalf of a whole bunch 
of other companies. I'm testifying not just on behalf of Adaptec, but 
160-some odd other companies. So you're not looking at a small mi- 
nority of folks at the table. 



29 

Senator Moseley-Braun. Yes. But your companies are kind of 
hyper-space when it comes to the market. You're out there and 
you're on the cutting edge. 

Mr. Adler. And we're the ones who are creating jobs. We're the 
ones who need help. 

Senator Moseley-Braun. Right. And I guess what I'm trying to 
get at is that we have an issue here. We have a problem here that 
is a market problem as well as a problem in terms of the operation 
of our legal system, as well as the operation of a very important 
agency that is there to protect investors. 

Now, given that, do you think it might be possible to get together 
to come up with some proposals or propositions and present those 
propositions and proposals to this committee, and then we can sit 
down, debate back and forth, this proposal makes sense because, 
and the same lawyers can come in and say, this proposal is wrong 
because, and then we can begin to approach our problem. Perhaps 
I'm missing something. 

Senator Dodd. Let me just say to my colleague, this is sort of 
what we're doing. There's no bill. Normally, when you have hear- 
ings, you have a bill and you're asking people to comment on a bill. 
For trie very reasons that you've identified here, there are some 
very contentious issues and some that need to be thought about. 
So we're doing 2 days of hearings to give people an opportunity to 
tell us what they think we ought to think about. 

Senator Moseley-Braun. Senator Dodd, I understand that. I ap- 
preciate that. I guess what I'm looking at is in addition to legisla- 
tion that's initiated by the committee or Members of the committee, 
that we could use some guidance from the people who are involved 
in the industry or involved on the front line with what it is, specifi- 
cally what it is that they see as approaches, problem- solving ap- 
proaches. 

In addition to telling us that these are the horror stories and this 
is our problem, which of course, we appreciate and appreciate your 
testimony to that extent and it's important that we hear about the 
problems. But in addition to that, to help us work toward solutions 
that are rational and responsive. 

Mr. McCracken. Senator, this is such an important issue, that 
we would certainly invest any amount of effort to come up with 
specific proposals that would change the situation. It's impacting 
the real creation of jobs. 

Mr. Adler. And I am very impressed with you Senators' under- 
standing of the issue. My primary objective for today was just to 
get across the message that there is a problem. There's a problem 
that stifles innovation. There's a problem that stifles creation of 
jobs, corporate governments, and world-wide competitiveness. I'd be 
very, very happy to go away from this testimony if I at least just 
planted a seed in your mind that this is potentially a very serious 
problem. 

Senator Dodd. Thank you very much. Thank you. 

Mr. Dunlap. Can I say a word on — the question earlier started 
off with, essentially, why isn't rule 11 sufficient because you can't 
sanction attorneys? I think the problem is, if you look at the situa- 
tion that I described, in the latest situation, I admit, I can't read 



30 

judges' minds. And I could put that in a disclosure, I guess, but 
that's not going to help anyone. 

We have a situation where the lawsuit was filed for a very little 
amount of money. We had to spend a lot of money to send the let- 
ter. And at that point, if they didn't accept that letter, after we 
spent hundreds of thousands of dollars to come up with the first 
letter that was generated by, say, a $100 filing, then we have a 
chance for these sanctions. 

I'm no expert in securities litigation. We've only had 2 in 25 
years. But practically, rule 11 is not effective in that situation be- 
cause there's such a great difference between what it costs to file 
and what it costs to defend. And on top of that, there's incentives 
for the plaintiffs that file. 

What we need to do is balance these incentives a little bit so it's 
not so cheap to file and it's not so expensive to defend, just to put 
the things in balance. And it seems that with the difference be- 
tween $120 and $500,000, we ought to be able to somehow get that 
number closer together. 

Senator Dodd. I appreciate that. Mr. Egan did also. He went 
down and listed four suggestions from the British rule idea which 
we've all heard about, the clear and convincing proof, professional 
plaintiffs and the like. 

What we might suggest to you and others, is that it's important 
that you submit at some point here for the committee, your views 
on numerous other ideas that are being floated around. But we'd 
like to hear some additional ideas or endorsement of the same ones 
that Mr. Egan has suggested. 

I would say to you very candidly, and it's no secret to some of 
you here, I have a real problem with the British rule idea. But, 
again, these are ideas that people may want to submit to us as we 
look and consider thoughts. 

Senator D'Amato. 

Senator D'Amato. Mr. Adler, I realize you're not an attorney, but 
you've had some experience in litigation. You hold up that com- 
plaint which you stated was filed and is still outstanding, and that, 
although the complaint alleges fraud, it fails to do so with specific- 
ity. Is that correct? 

Mr. Adler. Yes, sir. 

Senator Dodd. Well, you have counsel. I don't know whether you 
have an insurance company. Mr. Egan says he doesn't buy insur- 
ance. That probably doesn't make him a target. Is that what you're 
thinking, Mr. Egan? 

Mr. Egan. I'm saying that it may be part of it. If the statistic 
that the number of strike suits has actually declined over the 
years — I'd be surprised at that. But if that's the case, it may be 
that the price of this liability insurance has skyrocketed so much, 
that people have stopped purchasing it. But, as I said, it's the prin- 
cipal target, the deep pockets of the insurance companies. 

Senator D'Amato. Let me go back to Mr. Adler. 

Mr. Adler, did your counselor raise as a defense, that plaintiffs 
have not pleaded fraud with the amount of specificity required 
under the law? 

Mr. Adler. We have not had a chance yet in over 2 years to get 
in front of a judge. 



31 

Senator D'Amato. You see, I think that then goes to Mr. Egan. 

If you're trapped in the circle where defense counsel finds it prof- 
itable to just prolong the litigation and not bring a motion to have 
it dismissed, the fact of the matter is, your attorneys should bring 
a motion to dismiss the case because plaintiffs have not complied 
with the requirement that allegations of fraud be pleaded with 
specificity. 

If you've got an attorney defending you who wants to milk the 
case because he's getting paid on an hourly basis by an insurance 
carrier that's what's going to happen. Lawyers will drag the case 
out. So, you may be victimized by your own counsel especially if 
your case has been pending for 2 years and no motion to dismiss 
has been filed. 

No. 2 

Mr. Adler. May I respond, Senator? 

Senator D'Amato. Certainly. 

Mr. Adler. Virtually all the motions to dismiss in the Federal 
courts in Northern California have been denied. 

Senator D'Amato. Has it been denied in this particular case? 
Have you made the motion to dismiss under rule 9? 

Mr. Adler. No, we have not because all of the motions have been 
denied on the basis of insufficient facts are available and until dep- 
osition, I won't rule on a motion. 

Senator D'Amato. I'm just suggesting that rule 9 exists to ad- 
dress this problem. As our colleague from Illinois suggested, this is 
a complex problem. We want to knock out frivolous lawsuits and 
we don't want lawsuits filed indiscriminately because the price of 
a stock drops 10 percent. 

There have been some claims that these securities class-action 
lawsuits have increased. Now I've got some figures here from the 
SEC and if you're looking at securities filings, the number of these 
cases has been steady over the last 10 years. If anything, the num- 
ber of these cases may have gone down a little bit. A total of 268 
cases throughout the entire Nation were filed in 1992 that were se- 
curities fraud class-action suits. 

I'm not suggesting to you that all 268 of these cases filed are 
meritorious. This number doesn't seem like an explosion though. 
The problem is that these lawsuits or the threat of these lawsuits 
create mayhem in the arena of capital formation and job creation. 

I understand that being included in one of the 268 class actions 
filed gives you a different perspective about what may be consid- 
ered a frivolous lawsuit. 

Mr. Dunlap, let me return to you again. In your opinion, why 
isn't rule 11 working? Or is it working? How can we make rule 11 
or its application better? Do you think something should be done 
to strengthen rule 11? What, if anything, would you suggest? 

Mr. Dunlap. I think your earlier statement about rule 9, yes, 
you can file a summary judgment motion. The way that I did it in 
those two suits was even before we get to rule 9, we sent a rule 

II letter. 

So it's only $500,000 or so in order to get all the documents to- 
gether and to send this rule 11. It's going to cost much more to ac- 
tually go through the discovery and to actually prepare and argue 



32 

and fight for summary judgment motion. The fact of fighting a 
summary motion judgment itself is very expensive. 

I think the other thing is that rule 11 is so discretionary, that 
it makes it difficult to enforce. Potentially, we could have some 
kind of specific formula for what happens in a situation where it's 
dismissed on summary judgment or something like that. 

Senator D'Amato. Do you think that narrowing the application 
of rule 11 would make it better? 

Mr. Dunlap. I'm not so sure it's narrow. But we try to make it 
almost like the computer can calculate the 10-percent drop in the 
price. We try to get the computer to calculate what the sanctions 
should be when the plaintiff loses. 

Senator D'Amato. All right. Mr. Chairman, I think we will most 
likely get into some detailed discussion with our SEC folks as to 
what, if anything, can be done to improve rule 11. 

Did you know that only 268 class-action securities lawsuits were 
filed in 1992, or did you think it was higher? 

Mr. Dunlap. I thought the number was higher. 

Senator D'Amato. I thought you might have, go ahead. 

Mr. Adler. I don't think the issue is necessarily how many cases 
that are filed, but its devastating effect on job creation, innovation 
and competitiveness. 

Senator D'Amato. I disagree. 

Mr. Adler. And further 

Senator D'Amato. No, wait. 

Mr. Adler. — that this causes us to limit our communication to 
the financial community. 

Senator D'Amato. Wait, wait, wait. If you come in and you create 
the impression that frivolous lawsuits are so pervasive tnat when- 
ever a stock drops 10 percent, bang, a computer generates a com- 
plaint at some law firm, and off we go to the races. 

I am not suggesting that any one frivolous suit may not be injuri- 
ous. Overall though, 268 such cases filed nationwide is far different 
than the picture described — that whenever there is a glitch in the 
market, everybody is the subject of a frivolous securities suit and 
that since it only costs $120 to file the suit companies can be 
blackmailed into paying a settlement. That's only my perspective. 
Reasonable people can disagree. 

Mr. Adler. Certainly. 

Senator D'Amato. Please allow me that. 

Mr. Adler. I just want to say that we call it extortion, not black- 
mail. 

Senator D'Amato. Well, extortion. OK We come from different 
parts of the country. 

[Laughter.] 

Thank you. 

Mr. Egan. Senator, I'm very surprised that it's that few. We 
came here prepared to talk more, I guess, about our specific cases. 
I think there are some other people lined up that probably can an- 
swer that, in particular, some of the plaintiff firms which I think 
are representing some of the bigger ones. Maybe we can just ask 
them how many cases they filed in 1992. 

Senator D'Amato. Again, I was very much surprised myself. 
These figures may not be totally accurate. I thought it would be 



33 

many more. I suggest that to my colleagues. I just saw these num- 
bers though and we should find out how accurate they are since 
this is such a contentious area. We want to preserve legitimate 
rights to sue and, by the same token, we want to come down hard 
on those who are clogging the legal system with frivolous lawsuits 
looking to extort money or just looking for an opportunity to enrich 
themselves. That's wrong and we certainly want to stop that. 

Mr. Egan. Thank you. 

Senator Dodd. Senator Bennett. 

Senator Bennett. Thank you, Mr. Chairman. I, too, would like 
to check the 268 number and find out where it comes from and 
what its basis is because my sense in the marketplace prior to be- 
coming a senator is that the problem is much more pervasive than 
the 268 number would indicate. 

I'm fascinated and I'm sorry I can't resist this with the Ranking 
Member of the Budget Committee here, with the idea of filing a 
lawsuit when somebody misses their forecast for the future. 

[Laughter.] 

I will simply leave it at that. 

[Laughter.] 

In an attempt to answer 

Senator Domenici. The computer would be humming, I'll tell 
you. 

Senator Bennett. Yes. 

[Laughter.] 

And to make Members of Congress personally liable might also 
have an interesting impact on things. 

In an attempt to come up with some kind of answer to the issue 
raised by Senator Moseley-Braun, I find, at least in my mind, a 
possible parallel in the criminal justice system. Before you get 
somebody in a major criminal charge, you have to go before a grand 
jury. It acts as a filter before there s a jury trial and the grand jury 
finds whether there is or is not probable cause. Very often, things 
get lost in the system. It does not go to final trial because the 
grand jury says there's not a certain threshold of probable cause 
here, and they do look at the facts. 

Now, Judge Wapner is probably not available, but somebody with 
a degree of common sense and the ability to move quickly, if there 
could be some mechanism that says that this kind of suit is a fish- 
ing expedition. 

Mr. Dunlap, perhaps you would have the ability to say, we think 
this is a fishing expedition and therefore, we can force it before a 
Judge Wapner and now there has to be a threshold and we're both 
there and v/e have the burden of proof that it is a fishing expedi- 
tion because we're the ones that forced it here. But the cost of get- 
ting it before that kind of a hearing is much, much less than the 
$500,000 you're talking about to come up with a rule 11 letter. Is 
there any possibility of that or is this just the wild notion of a lay- 
man? 

Mr. Dunlap. I think that some form of a streamlined summary 
judgment type procedure certainly would work so that we don't 
have to go through all the discovery. That's really what takes all 
the time and money, is to search all our files for all the documents 
that they typically ask for. 



34 

Senator Bennett. Well, I won't prolong this, Mr. Chairman. I 
have to be elsewhere and I apologize to the later witnesses for the 
fact that I can't stay later. 

We have a Utahan here that I want to be here and get all excited 
about, but — I would just close by saying my own experience ratifies 
what's been said about the difficulty of getting directors to serve 
on boards. 

I've had the experience of calling directors and saying, would you 
serve on our board? And the first question they ask is how good 
is your O&D insurance and how insulated will I be? I've had direc- 
tors say, no, I won't serve on a board. 

This was in a private company that didn't have a stock price. But 
he said, "at some future point, you're going to go public," and we 
did. And he said, "I don't want to be exposed to that kind of thing, 
and I'm sorry, I won't do it." 

The second issue which, just a philosophical kind of thing, but 
if we can find a way to truly level the playing field between plain- 
tiffs and defendants in terms of costs, we really need to do it. 

One of the major issues in my State is what we call the 29-cent 
appeal. Now you talk about $125. There are people who can shut 
down, and have shut down lumbering companies with a 29-cent let- 
ter, filing an appeal, saving, we dont think that this is an appro- 
priate thing for the timber company to be doing and there will be 
6 months of hearing and it's found to be frivolous. But in the mean- 
time, the market has passed. And it's one of the reasons why the 
cost of a home in the United States is now $4,000 higher than it 
used to be, because the cost of timber is going through the roof. 

So it's the same general concept, that the people who file the ap- 
peal don't have any risk and don't have any costs. And the people 
who have to respond with legitimate facts are saddled with both. 

With that, Mr. Chairman, thank you. 

Senator Dodd. Thank you very much. I just point out that rule 
11 of the Federal Rules of Civil Procedure states that an attorney's 
signature on a pleading, motion or other paper filed with the court 
constitutes that attorney's certification that the information is well 
grounded in fact and is warranted by existing law, and that it is 
not interposed for any improper purpose, such as to harass or 
cause unnecessary delay or needless increase in the cost of litiga- 
tion. 

This rule obviously, as we all know, gives Federal iudges at least 
the authority and discretion to assess fees, including attorneys' 
fees, upon attorneys who violate the law. So there is a protection 
the^ Whether or not it's utilized enough, whether or not it's clear 
enouo-i, those are the things that we can assess and look at. But 
there is a mechanism at least today that allows for something akin 
to the British rule, if you will. 

Mr. Egan. Senator, it does exist. But it is not enforced. The 
judges will just let the motions go on and on. It turns out the pun- 
ishment is in the process. It's no* the absoluteness. 

Senator Dodd. I appreciate that, Mr. Egan. 

Mr. Egan. That's why they get settled. That's why they always 
wind up getting settled. 

Senate Dodd. I appreciate your point. However, we're going to 
have to, at some point, decide whether to craft some words that 



35 

deal with a statute. And every time you do that, there are benefits 
and potential liabilities. It's an imperfect way of communicating, in 
a sense, but you have to try and wrestle with those concepts and 
ideas. 

I just want to make sure the record is complete in the sense that 
a rule does exist which shows that some people have given some 
thought to the exact fact situation that some of you have described 
where you pay incredible costs, and particularly where there's friv- 
olous suits involved, and wonder whether or not there's any ability 
to go back and to recoup some of those costs. At least on the books 
there exists the ability to do it. 

Now you've identified the problem that maybe judges don't do it. 
Anyway, we've kept you long enough. I have more questions, but 
I'm going to submit some of them to you in writing here, rather 
than keep you here because we've got two other panels to get to. 

You've been very generous with your time and we're deeply 
grateful to you for your testimony. You're not attorneys, with the 
exception of Mr. Dunlap, and not necessarily expected to come and 
perform in hearings like this. I appreciate that. 

Your jobs are business leaders, to produce products that hire peo- 
ple and create capital and wealth in this country, and you've done 
a magnificent job of that. It takes a special willingness to come be- 
fore a congressional panel and to compete in a forum that is not 
terribly familiar to what you do in making a living. So we're grate- 
ful to you for doing that and you've been extremely articulate in 
expressing your concerns. This committee, I'm confident, is going to 
take them into serious consideration as we look at these matters. 

I'm sure other Members may have additional questions for you 
and hopefully, you can get those back to us so that we can make 
this a complete record and available to our other colleagues as we 
go forward here and try and decide what's the best way to proceed 
so that we strike the balance that I know all of you here are anx- 
ious for us to do. 

With that, I thank you. 

Mr. Egan. Thank you for having us. 

Senator Dodd. Our next panel is here, and I'll ask you to join 
us in the order I've introduced you. 

Mr. William McLucas, who is the Director of the Division of En- 
forcement for the SEC. 

Mr. Mark Griffin is the Director of the Securities Division for the 
Department of Commerce, from Salt Lake City, now that Senator 
Bennett has left. 

Professor Joel Seligman, from the University of Michigan School 
of Law. 

Ms. Patricia Reilly, AG Edwards Company in San Diego, CA. 

And Dr. Vincent O'Brien, Law and Economics Consulting Group, 
Incorporated, Emeryville, CA. 

We thank you. 

Senator DOMENICI. Mr. Chairman, while they're taking their 
seats, could I inquire of you regarding the intention to continue the 
hearings and when we might recess for lunch. I have to do some- 
thing on the Senate floor. 



36 

Senator Dodd. My hope was, quite frankly, to sort of plow along 
because if we break, then it is hard to get people back. I'd like to 
move on. 

We took a little bit longer time here. We had a lot of opening 
statements. Here, maybe we can move along and then get to our 
last panel. 

I figure if we break, it's so much more difficult in the afternoon. 
I've got a ton of stuff this afternoon, so I'm going to try and charge 
ahead. 

Senator Domenici. All right. Let's see what happens. 

Senator Dodd. Yes. Come on in here, folks. Mr. McLucas, you're 
at the end. 

All right. We've got everybody here. Again, I think you all were 
here. You heard me make the point, your full statements will be 
incorporated into the record. 

Mr. McLucas, we welcome you to the committee. We'll begin with 
you. I'm going to have that clock on here so that we can try and 
move a little more quickly here. I apologize. You've been sitting 
here a long time, but hopefully, that testimony was valuable for all 
of you to hear, from people within the business community. 

You're on. 

STATEMENT OF WILLIAM R. McLUCAS, DIRECTOR, DIVISION 
OF ENFORCEMENT, SECURITIES AND EXCHANGE COMMIS- 
SION, WASHINGTON, DC 

Mr. McLucas. Mr. Chairman, I appreciate the opportunity to ap- 
pear on behalf of the Securities and Exchange Commission to dis- 
cuss the issues related to private litigation under the Federal secu- 
rities laws. 

A number of parties believe that abuses of the court system have 
become so prevalent, that Congress must enact legislation that 
would curtail meritless securities litigation. 

Citing a litigation explosion, proponents of litigation reform have 
argued that the cost of defending a securities fraud action is so 
high, and the potential liability so great, that defendants are co- 
erced into settling cases which they almost certainly would win at 
trial. 

They have also argued that the settlements and class-action se- 
curities cases generally have little or no relationship to the merits. 

Let me say at the outset that you're going to hear from constitu- 
encies on both sides of the issue of litigation reform, those who are 
going to tell you that litigation is out of hand, that the system is 
being routinely abused, and those who are going to tell you that 
theyre always on the side of the angels and that the defendants 
are always tne bad guys. 

The reason these hearings are important, in my view, is that it 
is vital not just that the process be fair, but the participants in the 
process, both the plaintiffs and the defendants, believe that the liti- 
gation system is fair. 

As a prosecutor, I can tell you that over the long haul, the effec- 
tiveness of the system requires that those subjected to it believe 
that it's fundamentally fair, regardless of whether they agree with 
the outcome in any given case. So for that reason, I tnink it's ap- 



37 

propriate that the issues that are going to be brought before this 
subcommittee get the consideration that they're going to get. 

The SEC has acknowledged the detrimental impact of meritless 
securities cases. To the extent that these claims are settled to avoid 
litigation, they impose a tax on capital formation. However, before 
any action is taken, we should examine the data very closely to 
evaluate the extent of the problem and proceed carefully to con- 
sider what legislative reforms deserve serious consideration. 

In attempting to discourage meritless cases, we ought to be care- 
ful that we do not compromise legitimate investor claims. The 
strength and stability of our Nation's capital markets depend in 
large part on investor confidence and the continued fairness and ef- 
ficiency of those markets. To maintain that confidence, investors 
must continue to have effective remedies against persons who vio- 
late the anti-fraud provisions of the Federal securities laws. 

The Commission itself devotes substantial resources to the detec- 
tion and prosecution of securities law violations. Approximately 
one-third of our budget goes to enforcement. The Commission, how- 
ever, will never be able to investigate or prosecute every instance 
in which a public company's disclosure is questionable or where in- 
vestors have been injured by less than accurate disclosure. 

Private actions, therefore, are essential to the Commission's en- 
forcement activities and provide additional deterrence against secu- 
rities law violations. Private actions differ in their objective from 
SEC enforcement proceedings. They are designed to enable de- 
frauded investors to seek compensatory damages and thereby, re- 
cover the full amount of their losses. 

Commission enforcement proceedings seek injunctive relief from 
wrong-doers, seek to deprive them of their ill-gotten gain through 
disgorgement and generally to deter violations through the imposi- 
tion of money penalties. While the disgorgement funds are made 
available to compensate injured investors, the amount of investor 
losses in any particular case usually exceeds the wrong-doers' ill- 
gotten gain. In other words, SEC enforcement proceedings cannot 
be an adequate substitute for private rights of action. 

In an ideal world, any investor who is the victim of fraud should 
recover 100 cents on the dollar and people who have done no wrong 
should pay nothing. Obviously, in practice, any system of civil liti- 
gation will depart from this ideal. 

Securities litigation in particular is costly and the parties are 
often faced with considerable uncertainty about the outcome. As a 
result, plaintiffs with good claims often settle for less and defend- 
ants who did nothing wrong may pay money to settle a claim with 
no merit. 

It is difficult to measure the scope of the problem and so far, the 
evidence is inconclusive and, in my view, points in both directions. 

On the one hand, some statistics indicate that the number of se- 
curities cases filed in Federal district courts has not increased over 
the past two decades. On the other hand, statistics from the Big 
Six accounting firms indicate that the costs associated with litiga- 
tion have been multiplied. 

The extent to which the problem is a function of State rather 
than Federal law is also unclear. The liability standard under sec- 
tion 10(b) and rule 10(b)(5) is knowing or reckless conduct, which 



38 

generally is described as an extreme departure from the standards 
of ordinary care. By contrast, the laws of many States permit ac- 
countants to be held liable only on a showing of negligence in the 
performance of an audit or negligent misrepresentation in audit re- 
ports. 

Consistent with these differing liability standards, a survey by 
the Big Six accounting firms found that Federal securities fraud 
claims — that is, cases predicated on rule 10(b)(5) alone — accounted 
for only a fraction of all claims against the accountants. In light of 
this uncertainty, Congress should proceed cautiously. There is a 
substantial danger that legislative reform targeted at frivolous liti- 
gation will also have an unintended effect on valid claims. 

Market confidence will be eroded if investors are unable to vindi- 
cate their rights whenever public companies or their professional 
advisors fail to discharge their responsibilities under the law. 

Finally, I would like to touch very briefly on some of the propos- 
als that have been suggested. 

Lengthening the Statute of Limitations 

After the Supreme Court's decision in Lampf in 1991, setting a 
3-year statute of limitations in rule 10(b)(5) cases, the Commission 
took the position that the period should be extended by statute. It 
should be lengthened to 5 years. Extending the limitation period 
does not encourage frivolous actions. Typically, strike suits are filed 
immediately after some unfavorable corporate event. 

RICO Reform 

The Commission supports legislative efforts to eliminate the 
overlap between private remedies under RICO and those available 
under the Federal securities laws. The threat of extraordinary rem- 
edies under RICO has a coercive impact that tends to impede cap- 
ital formation and places inappropriate financial burdens on com- 
mercial defendants. 

Class-Action Reform 

The Commission has expressed general support for measures 
that would prohibit certain payments to class representatives, 
would prohibit service as class counsel by persons with a beneficial 
interest in the securities that are the subject of the litigation, and 
would prohibit the payment of referral fees by class counsel. 

Fee-Shifting 

If Congress adds a fee-shifting provision to section 10(b) of the 
exchange act, it should only require the loser to pay if a court con- 
cludes that the case is without merit. Section 11 of the 1933 act 
already has such a fee-shifting provision and the subcommittee 
might consider whether a similar provision in the exchange act 
would deter frivolous claims without having a significant chilling 
effect on meritorious actions. 

Senator D'Amato. Would you state that again, and tell us why? 
That's pretty important to just rip it off. I want to hear you. 

Mr. McLucas. Well, basically, what I said, Senator, is that we 
would support something short of loser-pays, something not akin to 
the English rule, which, in essence, permits a court, as is the case 



39 

under section 11 of the 1933 act, which applies liability to those 
who expertise segments of a registration statement. 

What the section provides is that if a court, in essence, decides 
that a claim is without merit, then the court has the discretion to 
impose some measure of costs on the party bringing the claim. I 
would recommend that those costs be imposed on the counsel or the 
lawyer, as opposed to the plaintiffs, particularly when we talk 
about class actions. 

Senator D'Amato. Would you be in a position to suggest in writ- 
ing some of that language? 

Mr. McLucas. We would be happy to work with the subcommit- 
tee, Senator, in drafting and in putting some meat on the bones of 
a proposal. But the concept is one which we think, if the sub- 
committee believes legislation is necessary, may be worth consider- 
ation. 

Senator D'Amato. Mr. Chairman, I commend that to the Chair 
and possibly we can have our staffs work with that. That seems to 
be an area that we're all concerned about, dealing with those frivo- 
lous suits, bringing a measure of penalty to those people who are 
responsible for bringing them, and yet, not having that chilling im- 
pact. Maybe that's the kind of balance we're seeking. 

Senator Dodd. We've looked at that already, but we'd appreciate 
the context of all of these ideas and certainly, well be back in 
touch with the SEC. You'll not be surprised if we make that re- 
quest for some ideas in that area. 

Mr. McLucas. 

Proportionate Liability and Contribution 

Congress should move cautiously on changing the principle of 
joint and several liability under the anti-fraud rules to that of pro- 
portionate liability. Such a change might adversely affect investor 
confidence because complete recovery inevitably would be denied to 
investors, even in some serious and meritorious cases. 

Proportionate liability may well be more appropriate in the con- 
text of State law claims for negligence. It seems more reasonable 
to hold a defendant who is merely negligent, liable only to the ex- 
tent of his relative culpable activity. 

Aiding and Abetting Liability 

Again, here, the subcommittee should be cautious of proposals 
that would change the standards and consequences of liability, as 
opposed to proposals which would deal directly with the issue of 
frivolous litigation. 

Currently, no defendant can be liable in an action under rule 
10(b)(5) of the Federal securities laws unless the defendant acted 
intentionally or recklessly, and that standard requires that the de- 
fendant be found to have engaged in an extreme departure from 
the standards of ordinary care. 

Some proposals would limit liability of professionals to only those 
cases where the plaintiff can prove actual knowledge or deliberate 
fraudulent intent. I believe those proposals go too far in insulating 
the professionals from liability. 

Mr. Chairman, in conclusion, the Commission encourages the 
subcommittee to give serious consideration only to those reform 



40 

measures that have the potential to deter meritless securities fraud 
cases. 

Before resorting to changes in the standards for liability or other 
measures that would affect both meritorious and baseless claims, 
it would be preferable to determine the effectiveness of measures 
more directly targeted at frivolous litigation. 

And, as always, we would be happy to work with the subcommit- 
tee in crafting any proposals that might come out of these hearings. 

Thank you. 

Senator Dodd. Thank you very much. 

Mr. Griffin. 

STATEMENT OF MARK J. GRIFFIN, DIRECTOR, SECURITIES 
DIVISION, DEPARTMENT OF COMMERCE, SALT LAKE CITY, UT 

Mr. Griffin. Thank you, Mr. Chairman. My name is Mark Grif- 
fin. I'm the Director of the Securities Division of the Utah Depart- 
ment of Commerce, and a member of the board of directors of the 
North American Securities Administrators Association, NASAA, on 
whose behalf I'm here today. 

NASAA is the national organization of the 50 State securities 
agencies in the United States. 

I want to express my appreciation to the committee for the op- 
portunity to be here today. 

Mr. Chairman, I know that you have a long list of witnesses here 
today who want to be heard. I'll keep my remarks brief. 

I want to begin by emphasizing that NASAA shares the concerns 
expressed here this morning about the need to curb frivolous litiga- 
tion, securities fraud claims in particular. 

However, it's NASAA's view that the initiatives that have been 
put forward in the name of litigation reform, including changes in 
how liability is determined, shifting of attorneys' fees and costs, 
new definitions for the burden of proof, and changes in the rules 
governing class-action proceedings, may unintentionally give free 
rein to financial swindlers and other sharp operators. 

While such changes may have the effect of eliminating a handful 
of dubious securities fraud lawsuits, it will eke out this minuscule 
benefit only by inflicting a massive harm; that is, an discriminate 
curb on access to the courts for all victims of financial swindles. 

Investors today have a profound and all-too-well justified sense 
of concern about the integrity of our financial markets. The ex- 
cesses of the 1980's and the 1990's, which are well known and do 
not need repeating here, serve as the backdrop against which we 
consider the issues under discussion today. 

Private actions have become an increasingly vital enforcement 
tool in light of the dramatic growth of fraud and corruption in the 
Nation's financial markets. Budget manpower restrictions at both 
the State and Federal levels argue in favor of broader private rem- 
edies, not the opposite, as would be the case if these so-called re- 
forms are adopted. 

No one, save those who have committed the fraud in the first 
place, benefits from a wholesale assault on these private rights of 
action. In short, private rights of action under securities laws are 
essential to deter prospective criminals, compensate the victims of 
fraud, and maintain public confidence in the marketplace. 



41 

For this reason, NASAA would strongly urge Congress to take 
immediate action to lengthen the statute of limitations for securi- 
ties fraud cases, and in doing so, modify the unfortunate 1991 Su- 
preme Court decision in Lampf. 

We believe that such legislation is vitally important and should 
not be delayed as a result of prolonged discussion of the broader, 
more complicated, and more contentious litigation reform measures 
that are now being advanced in certain quarters. 

Mr. Chairman, it has been estimated that securities litigation ac- 
counted for less than 1 percent of all cases filed in Federal court 
in fiscal 1991. Given this, we fail to see how dramatically limiting 
access to the court for defrauded investors will result in any signifi- 
cant decrease in the overall litigation caseload. Moreover, why are 
we singling out defrauded investors for experimentation with new 
rules and procedures designed to make it difficult to bring suits for 
redress? 

Further, it's NASAA's view that the courts currently have the 
tools necessary to deter frivolous or baseless suits and may do so 
without sacrificing important investor rights. 

The Federal rules of Civil Procedure contain ample legal safe- 
guards for the prevention and suppression of unwarranted or abu- 
sive securities suits. Emerging anecdotal evidence suggests that 
these rules are now being invoked on a more frequent basis. If 
there is a concern on the part of Congress that these rules are not 
being applied often enough or rigorously enough, let us find out 
why, so that we do not prematurely cut off investors' rights due to 
judicial shortcomings. 

I will not comment now on each of the proposed reforms but I 
would like to say a word about proportionate liability and aiding 
and abetting liability. 

Our scheme of securities regulation casts professionals, account- 
ants and lawyers in the role of the guards at the gate. If there is 
a breach, owing to the guards' lack of vigilance, then the guards' 
exposure ought to reflect the harm to investors caused by that lack 
of vigilance. 

It is pointless and, more importantly, bad policy, to limit the 
guards' exposure to the extent of the guards' own participation in 
sacking the town. The concept of joint and several liability is im- 
portant and should be retained. 

Mr. Chairman, and Members of the subcommittee, NASAA would 
respectfully request and urge you to reject the initiatives that are 
now being promoted as litigation reform. Although these proposals 
have been dressed up in anti-lawyer rhetoric, they may also legiti- 
mately be seen as being anti-investor as well. 

NASAA believes it would be unwise in the name of reform to fur- 
ther restrict the ability of defrauded investors to be made whole. 

Thank you, Mr. Chairman. 

Senator Dodd. Thank you very much. 

Professor Seligman. 

STATEMENT OF PROFESSOR JOEL SELIGMAN, UNIVERSITY OF 
MICHIGAN LAW SCHOOL, ANN ARBOR, MI 

Mr. Seligman. Yes, Senator. Senator, I'd like to offer some obser- 
vations, neither from the point of view of a plaintiff, nor from the 



42 

point of view of a defendant, but to give you a kind of broader, sys- 
temic overview of the issues before you. 

Let me first highlight the current moment. There is no objective 
data that suggests that litigation has contributed to a dimunition 
in capital formation. 

According to the SEC, in its most recent annual report, for exam- 
ple, the total dollar amount of securities filed for registration with 
the Commission during 1992, reached a record of over $700 billion, 
a 40-percent increase from the previous year. 

We additionally see that at the current moment, there are well 
over 50 million individual investors, which is greater than any 
other country on earth. 

I'd like to submit to you that one of the reasons that the United 
States has realized its current level of capital formation and the 
breadth of securities ownership in this country is the mandatory 
disclosure system, which gives investors confidence that they can 
buy securities on the basis of all material facts. 

Now underlying this mandatory disclosure system is a litigation 
system which in effect enforces it. I'd like to submit that, to the 
best of my knowledge, based upon a relatively recent statement 
from former Chairman David Ruder, only about 10 percent of the 
litigation that is brought in the Federal securities law area is in 
fact brought by the Government. Approximately 90 percent is initi- 
ated by private claimants of some sort. 

To be sure, private litigation is not perfect. But I want to high- 
light more than anything else today that this is an area where the 
judiciary has performed an active and, in my view, wise effort in 
shearing out the non -meritorious from the meritorious in litigation. 

We have seen, for example, in recent years an increase in the 
number of lawsuits dismissed on the basis of the complaint under 
rule 9 of the Federal Rules of Civil Procedure. 

We have seen an increase in several jurisdictions and I would 
emphasize, most notably, the northern district of California and the 
southern district of New York, in the willingness of Federal district 
court judges to use rule 11 sanctions. 

We have seen overtime in the rule 10(b)(5) area, a narrowing of 
the ability of plaintiffs to go forward, whether it was because of the 
Lampf decision, which typically shortened the statute of limita- 
tions, or the decision that Senator Domenici — I hope I haven't mis- 
pronounced that 

Senator Dodd. Senator Riegle probably mispronounced your last 
name, too, so 

[Laughter.] 

Mr. Seligman. I'll still vote for him. 

[Laughter.] 

Senator Domenici. Senator Pete. 

Senator Dodd. Yes, Pete. 

[Laughter.] 

Mr. Seligman. The Senator from New Mexico, who began his 
statement by quoting Chief Justice Renquist in the Blue Chip 
Stamps decision, which narrowed the ability to go forward on the 
basis of standing. 



43 

We've seen reference on a couple of occasions so far to the cul- 
pability standard, which, as Bill McLucas accurately stated, is ei- 
ther intentional misconduct or recklessness. 

But in the 11 circuits out of the 12, which is the court of appeals 
level, have recognized recklessness as an appropriate culpability 
standard, most of them have formulated it more narrowly than 
that, to a severe recklessness standard. 

So that what you see when you look at litigation at the moment 
is whether, because of the general Federal Rules of Civil Procedure, 
or because of the precise rules of rule 10(b)(5) litigation, there has 
been some narrowing and some ability which has been used — I 
really want to emphasize that — by the district court judges to at- 
tempt to distinguish the meritorious from the non-meritorious. 

Now it's been suggested on a number of instances by the first 
panel that a recent case involves nothing more than a drop in the 
stock price. Instantaneously, it's been filed. 

Well, I will submit to you, Senator, that certainly within the last 
2 years, there have been a number of dismissals of lawsuits on the 
basis of the complaint when that was all the plaintiff filed and all 
that they could identify. In some instances, there have been rule 
11 sanctions as well. In other words, the judiciary is responding to 
the perceived abuses. 

At the same time, I want to highlight that when you look at com- 
panies such as those you looked at this morning, there is a certain 
amount of demonology here. You will hear equally aggressive ter- 
minology to strike suits used by plaintiffs to characterize wayward 
corporate managers or their accountants or what have you. 

In the broader sense, though, the issue is not whether or not we 
have some bad plaintiffs' attorneys or some bad defendants. The 
real issue here is whether the overall system deters securities 
fraud. I want to highlight, it's at that level the system seems to be 
working well. It's at the ability of investors to feel confident they 
can buy stock. It's at the ability of the market to generate new 
funds for business corporations that there seems to be a very slight 
case for reform. 

Finally, if I can just offer one — I use the term, anecdote. 

My recent experience as a court-appointed disinterested person 
in a shareholder derivative litigation in the western district of 
Michigan suggests to me that probably, if you wanted a balanced 
approach to litigation reform, the one area which at the moment 
deserves the most attention is discovery. 

The cost of discovery has metastasized in recent years. It has 
grown in part not because the litigation is non-meritorious, but be- 
cause you typically see more complicated complaints. It has grown 
in part because you see more derivative parties involved. 

I would submit to you that I do not believe this is a special prob- 
lem in securities law. I think it's a more appropriate one for those 
who address the Federal Rules of Civil Procedure. But of all the 
litigation "reform" proposals on your plate, that is the single one 
that strikes me as worthy of the most serious attention. 

Senator Dodd. Very good. Thank you very much, Professor. 

Ms. Reilly. 



44 

STATEMENT OF PATRICIA REILLY, AG EDWARDS COMPANY, 

SAN DIEGO, CA 

Ms. Reilly. I want to thank Chairman Dodd and the other Mem- 
bers of the Securities Subcommittee for giving me the opportunity 
to relate my experiences as a stockholder in some security class- 
action lawsuits. 

I have been a shareholder in two different security class-action 
lawsuits. One was against Pace Membership Warehouse. The other 
was against Tucson Electric Power. Both lawsuits alleged fraud 
was committed by the companies' officers and directors which re- 
sulted in my losing money on my stock investments. 

I am the small investor for whom these class-action lawsuits 
were created, the shareholder who had too little at stake to individ- 
ually sue a company for fraud. 

In Pace Membership Warehouse, I had invested $3,167.51 into 
200 shares. My loss was $1,517.51. In Tucson Electric, I bought 200 
shares, for a total investment of $10,677.46. My loss was $5,595.56. 

In both lawsuits, there was a settlement offer. The Pace offer 
was for $9,125,000. The lawyers were requesting 40 percent out of 
the settlement fund, plus $600,000 in out-of-pocket expenses. In 
Tucson Electric Power, the settlement offer was for $30 million. 
The lawyers requested 30 percent, or $9 million, in legal fees. In 
both cases, the settlement funds were to come from insurance pro- 
ceeds. In neither case did the defrauding officers and directors pay 
a dime. Nowhere in the settlement notices were the stockholders 
told of how much they could expect to recover of their losses. 

Because I felt the requested attorneys' fees were outrageous, ex- 
cessive, and exorbitant, at my own expense, I took time off of work 
and flew from San Diego to the respective settlement hearings in 
Denver and Phoenix to object to the legal fees. 

In Pace, the lawyers were ultimately awarded approximately 
$3,300,000 in legal fees. Basically, the lawyers had $2,090,438 in 
billable hours. There were five law firms with 35 attorneys rep- 
resenting the stockholders. The lawyers on the shareholders' side, 
spent 8,935 hours on the case. The highest paid attorney for the 
shareholders charged $450 an hour. In addition to the $2 million 
in billable hours, the court gave the attorneys $1,300,000 as a 
bonus for doing such a good job in the case. 

As a result of the settlement, the stockholders got back 17 cents 
on the dollar of their losses. The defrauding defendants did not pay 
a dime. Of my $1,517.51 loss, I recovered $250.51. 

In Tucson Electric, the court awarded the lawyers $7,845,000 in 
legal fees. The actual billable hours were a bit under $3 million. 
There were 35 law firms, 177 lawyers, 77 paralegals and law clerks 
representing the stockholders. There were 10,741 hours spent on 
this case by the shareholders' attorneys. 

One attorney representing the shareholders charged at a rate of 
$500 an hour. Fourteen other lawyers charged between $400 and 
$500 an hour, and 51 lawyers charged between $300 and $400 an 
hour. However, the court did not award the lawyers just their 
hourly fees of roughly $3 million, but awarded them $7,845,000, or 
a bonus of approximately $4,845,000 above their billable hours. 

As a result of the settlement, co-counsel for the shareholders' at- 
torney told me I can expect to recover 4 to 5 cents on the dollar 



45 

of my losses. That would mean, of my $5,595.56 loss, I can expect 
to recover $279.78. 

At my own expense, I presently have the Tucson Electric case on 
appeal at the U.S. Court of Appeals. I feel that the settlement offer 
should have told the stockholders how little of their losses will be 
recovered in the settlement and that this is a material fact to the 
shareholders' decision to approve or disapprove of any settlement. 
Without this fact, the shareholders were denied due process of law. 

As a result of my experiences, I have come to realize that secu- 
rity class-action lawsuits exist for the benefit of the shareholders' 
lawyers. The stockholders, the victims of the fraud, recover vir- 
tually none of their losses. 

In the vast majority of the cases, the stockholders recover less 
than 10 cents on the dollar of their losses. Ninety-six percent of the 
class-action lawsuits settle. The cases normally settle for the 
amount of the directors' and officers' liability insurance and noth- 
ing more. Usually, the directors and officers who committed the 
fraud do not pay a dime. Meanwhile, the stockholders' lawyers 
make millions. 

As a stockholder, I feel that the lawyers use the stockholders as 
stepping stones, preying on their misfortune as a means to file a 
lawsuit that will inevitably settle, in which the lawyers will reap 
millions in fees while their clients recover pennies on the dollar of 
their losses. 

One possible solution that I would recommend is that the share- 
holders' lawyers receive as legal fees the same percentage of the 
settlement fund that the stockholders recover of their losses. 

As an adjustment to that concept, I would say that since nor- 
mally, we do not want to discourage suits against the directors and 
officers or other parties where there is fraud involved, I would limit 
this rule that the shareholders' lawyer receive as legal fees the 
same percentage of the settlement fund that the stockholders re- 
cover of their losses, when the basis of the settlement fund is insur- 
ance. 

A second recommendation is that the settlement notice inform 
the stockholders what percent of their losses they can expect to re- 
cover if they accept the settlement versus proceeding to trial, which 
is an option, proceeding to trial. 

Three, the shareholders' lawyers are paid their fees at the same 
time that the stockholders receive their distributions. Oftentimes, 
the lawyers are paid shortly after the settlement hearing and it's 
years before the stockholders recover any distribution. 

Finally, that the officers and directors should be truly held ac- 
countable if they committed fraud. Although the officers and direc- 
tors would never be able to reimburse the stockholders for the mas- 
sive losses that normally occur in these cases, the stockholders 
would feel that at least if they do not get their money back, the 
guilty people were held accountable. 

As the system is presently set up, the victims, the stockholders 
who lost their money through fraud, are not compensated and the 
offenders who caused the losses are not held accountable. The suits 
are really brought so that the shareholders' lawyers can suck 
money out of insurance companies in order to make millions in 
legal fees. 



46 

And one final thing I would like to say in comment to Senator 
Shelby's statement, who is not here. Senator Shelby stated that he 
was interested in protecting the investors. He mentioned two inves- 
tors that would be appearing here today — Gordon Billipp and Mr. 
Ramser. 

There are three investors that are appearing here today. Two 
were selected by plaintiffs' attorneys for their recoveries, Mr. 
Billipp and Mr. Ramser. 

I'm here as an investor. I have lost money. I have not recovered 
my money. We'll get 5 cents on the dollar as a result of this great 
legal work. What I would like to ask Senator Shelby is what he 
plans on doing to the people like myself who really represent the 
norm? 

I'm here on my own dime. I'm here on my own voice. What is 
going to be done for the people like us who do not recover anything, 
that basically get sold down the river by our attorneys for peanuts 
so that they can recover 25 percent in legal fees of these million- 
dollar settlements. 

Thank you very much, Senator Dodd, and the other Members of 
the committee. 

Senator Dodd. Well, thank you very much, Ms. Reilly. With a 
name like Reilly, I didn't think we'd nave to question what your 
views were on these matters. 

[Laughter.] 

I was going to make note of it if it hadn't been. You said it and 
you said it better than I could. You're here on your own dime. 

Ms. Reilly. Thank you. 

Senator Dodd. I think people ought to note that and appreciate 
it immensely as a citizen stepping forward here. We appreciate 
your presence here immensely. 

Dr. O'Brien. 

STATEMENT OF DR. VINCENT E. O'BRIEN, LAW AND 
ECONOMICS CONSULTING GROUP, INC., EMERYVILLE, CA 

Dr. O'Brdzn. Yes, thank you. My name is Vincent E. O'Brien and 
I hold a bachelor's of science degree in electrical engineering with 
high honors from the University of Illinois. I have a master s and 
doctorate in business administration from Harvard University. 

For the last 15 years, I have specialized in providing economic 
and financial analysis for attorneys involved in complex litigation. 
In this process, I have worked for both plaintiffs' and defendants' 
firms. In the last 8 years, I have worked on and testified in securi- 
ties class-action cases. 

My experience in those cases has led me to believe that private 
enforcement of public policy under rule 10(b)(5) indeed serves a 
useful purpose. That, however, is not the question before this com- 
mittee, nor should it be. Instead, the appropriate question is 
whether the current law is working effectively and efficiently. 

To answer these questions, I performed a study of my own and 
I reviewed subsequent studies that were conducted. These studies, 
I believe, reveal that the current situation provides little in the 
way of deterrence, fails to protect harmed shareholders, and im- 
poses significant costs on innocent defendants. In short, I believe 



47 

the studies are unanimous in saying that we have a serious prob- 
lem that needs to be fixed. 

The most comprehensive study of rule 10(b)(5) actions is the one 
that I performed. It was first done in 1991 and was just updated. 
Indeed, you're going to receive the very first copy of it today. 

That study adds 230 cases to my original data and information 
on 100 more of the original cases. Altogether, I have reviewed 533 
security class-action cases reported in the last 5 years. The study 
revealed at least six general conclusions of interest to this commit- 
tee. 

First, it is very common to be sued under the law. One out of 
every eight companies traded on the l^ew York Stock Exchange 
was sued in the last 5 years— one out of eight. On the American 
Stock Exchange, it was one out of 18. On the automated quotation 
system of the NASD, it was one out of 20. Altogether, 342 compa- 
nies paid $2.5 billion in settlements in the last 5 years. 

The second thing revealed by the study is that a disproportionate 
share of the cases were against the young, medium-sized, high- 
technology firms like those we heard from earlier today. One-third 
of the cases involved companies less than 10 years old. Likewise, 
a third of the suits involved companies whose sales were under 
$100 million, and 61 percent involved companies whose sales were 
under $500 million. The high -technology industries consisting of 
electronics, computers, instruments and medical devices accounted 
for one out of every four of the suits. 

Senator Domenici. Would you state that again, please? 

Dr. O'Brien. The high-technology companies, and I've defined 
those as companies in the electronics, computers, instrumentation 
industries and medical device industries, accounted for 25 percent, 
one out of four of every one of the suits. 

Third, even though certain types of companies like these are 
prone to litigation, almost any corporation is a possible target. I 
classified all of the industries sued by their standard industrial 
classification and found that virtually every industry was rep- 
resented. 

Likewise, being a mature company did not protect you from one 
of these suits, as two-thirds of the suits were against companies 
that were over 10 years old. Companies with over $10 million in 
sales were sued as frequently as companies under $10 million in 
sales. 

The fourth major conclusion revealed by the study is that vir- 
tually all of these litigations are resolved through settlement. Out 
of 365 cases resolved in the last 5 years, only five reached a jury 
verdict, 21 were dismissed or withdrawn. In all, 93 percent of the 
securities class-action cases in my sample were settled out of court. 

This is an extremely high settlement rate, as the norm in most 
other civil cases is only 60 to 70 percent. Typically, over 30 percent 
of the cases are dismissed or dropped for other reasons. In this 
way, cases that are weak or without merit are weeded out. This 
process is not happening here. Instead, we have a situation that is 
common for virtually every firm that is sued to be compelled to pay 
a settlement. I think we heard some of the reasons for that earlier 
today. 



48 

The fifth conclusion revealed by my study is that individual in- 
vestors get little direct benefit from the class-action suits brought 
on their behalf. Most of the shareholder losses are suffered by the 
large institutional investors and it's they who receive the bulk of 
the settlement fund. 

In the most extreme case I examined, five claimants out of 302 
received 36 percent of the settlement. In another, 52 percent of the 
settlement went to 1 percent of the claimants. Not one of those 
claimants was an individual. 

Now, it's appropriate to protect institutional investors under the 
law. 

Senator Dodd. Who were they? 

Dr. O'Brien. Pardon? 

Senator Dodd. Who were they? I'm sorry. Not one? 

Dr. O'Brien. Not one of the top claimants — 52 percent of the set- 
tlement went to 1 percent of the claimants and not one of those 1 
percent was an individual. 

Senator Dodd. Institutional investors. 

Dr. O'Brien. They're all institutions. Now while these institu- 
tions are entitled to protection, it's important to remember that 
most of the allegations in these cases involve information that is 
readily accessible to institutions. It may be difficult for a small in- 
vestor to spend the time and money to gather it, but the institu- 
tions are in a position that they can and, indeed, do gather that 
type of information. 

The sixth conclusion, and perhaps the most disturbing one, is 
that settlement amounts in these cases are relatively low when 
compared to the losses. 

On average, the cash amount of the settlement was 6 percent of 
the total trading losses for purchasers of common stock during the 
relevant period. This is before their attorneys' fees, which can be 
as high as a third of the recovery, are deducted. 

Not only are plaintiffs not receiving much compensation, it is 
doubtful that these settlements are providing an efficient deterrent 
to fraud. 

Fully 40 percent of the settlements were for less than $2.5 mil- 
lion. This is less than the defendants' cost of taking one of these 
cases to trial. Settlement for less than the defendants' litigation 
cost is an indication that the case was weak or without merit, as 
the plaintiff is choosing to avoid a test of the merits in the court. 
The bringing of weak or meritless cases by definition would have 
a minimal deterrent effect. So that takes care of 40 percent of these 
actions. 

Another 43 percent of the settlements were between $2Vz and 
$10 million, and another 13 percent were between $10 and $20 mil- 
lion. These are the amounts of the typical insurance coverage by 
these firms. And in fact, settlements are often done for the insur- 
ance proceeds alone. 

Settlements limited to the insurance company would offer little 
deterrence as the parties at fault rarely bear the burden of in- 
creased premiums. Thus, it would appear from my study that fully 
in 94 percent of the cases, there can be no deterrent effect. In only 
6 percent is there a potential for deterrence. 



49 

When I first started my research, there had been no studies in 
this area. Since then, three other studies have been released. 

The first one was done by Janet Cooper Alexander at the Stan- 
ford University School of Law. Professor Cooper Alexander exam- 
ined litigation arising out of 17 initial public offerings of stock by 
similar computer firms in the first half of 1983. When she found 
that settlements were similar in nearly every case, about 24 to 27 
percent of the computed losses, she concluded that the cases had 
settled without regard to the merits. 

Her conclusion was met with a hailstorm of criticism. I won't go 
into that, as much of it doesn't bear repeating, and what does I 
think misses the point. The point is that even after you take the 
criticism into account, the study does not prove that the cases were 
settled on the merits. That failure, I feel, should be of concern to 
all of us who are looking at this litigation. After all, cases should 
be adjudicated on their merits. 

Another study was done by an economist, Fred Dunbar. It ex- 
tended my initial study for tne period ending in June, 1992, with 
many of the same results. Mr. Dunbar did, however, find that both 
the number and size of settlements were increasing. He also found 
that the settlements amounted to approximately 3 percent of share- 
holder losses. 

A third study which has not yet been released by Zoe-Vonna 
Palmrose, who is an associate professor at the University of South- 
ern California, has also been completed. In it, she examines 400 se- 
curities class-action suits filed against auditors from 1960 to 1992. 

Her study shows that in 65 percent of these matters, almost two- 
thirds of them, the auditors paid less than $1 million. Given an av- 
erage defense cost for these auditors of $3V2 million, she concludes 
that those plaintiffs' cases must have been weak as well. 

I believe that the conclusions that one should draw from these 
studies are clear. 

First, there is way too much of this type of litigation. With one 
out of every New York Stock Exchange firm having been sued in 
the last 5 years alone, and virtually all of them paying a settlement 
fee, one has to be concerned. 

Second, with such indiscriminate filing and settlement, the cur- 
rent law is providing little deterrence. A remedy that can be in- 
voked with essentially the same level of success in virtually every 
case, regardless of the true merit of the claim, does not single out 
and punish wrong-doers. 

Third, with shareholders recovering only a few cents on the dol- 
lar, the law is not providing any significant compensation. 

Now I believe these problems are peculiar to rule 10(b)(5) types 
of actions. In civil cases, 30 to 40 percent of all actions are termi- 
nated without trial or settlement. Weak cases are fought by defend- 
ants and weeded out through the normal judicial process. 

As the 93-percent settlement rate shows, that does not happen 
in securities class actions. What is needed are remedies that would 
change the system to encourage plaintiffs to press only meritorious 
claims and encourage defendants to resist non-meritorious claims. 

Thank you. 

Senator Dodd. Thank you very much. Excellent testimony from 
all of you. We appreciate it immensely. 



50 

Let me share a few questions with you. 

Ms. Reilly, let me begin by asking you a question that occurred 
to me while you were talking. 

One of the things we've talked about here is the importance of 
retaining investor confidence. It's critically important. And we've 
talked about the importance of penalizing those defendants who 
have defrauded investors through SEC actions and, of course, in 
private litigation. 

You bring a different perspective to this a bit. You're on the 
other side of this. And I was sort of curious listening to you testify, 
whether or not, as a result of what you've been through, have you 
lost confidence as an investor? 

Ms. Reilly. Well, I wouldn't say that I would expect that these 
lawsuits would give me confidence. In terms of buying stocks? 

Senator Dodd. Yes. 

Ms. Reilly. I would be basically looking at it, buying the stock 
at caveat emptor. If there's fraud — if I'm buying the stock, I figure 
I can't protect myself against fraud. And you hope that there isn't. 
And if there is fraud, I wouldn't expect that the legal process will 
reimburse me in any way. 

Senator Dodd. All right. It just struck me while you were testify- 
ing whether or not you would fall into the category of being a con- 
fident investor, as I listened to your testimony. 

Voice. Mr. Chairman, would you use your microphone, please? 

Senator Dodd. I apologize. 

Ms. Reilly. Being a competent investor, did you say? 

Senator Dodd. A confident investor. 

Ms. Reilly. Oh, confident. 

[Laughter.] 

I thought after my losses, you were questioning 

[Laughter.] 

Senator Dodd. I'm not questioning your competency at all. 

[Laughter.] 

I'm sorry. Did you understand my question, then? 

Ms. Reilly. Yes, I did, I think. 

Senator Dodd. OK. Professor, you gave eloquent testimony here. 
One of the things that struck me as you were talking again about 
investor confidence and the importance of retaining that, not to 
mention capital and so forth, is whether or not the complaints we 
heard from the first panel, one of their concerns was deterring eco- 
nomic growth, attracting capital. 

I wonder if, in the process of looking at this whole systemically, 
you've looked at it and you've particularly commented on if we're 
to weaken in some way the procedures here, that we might contrib- 
ute to a deterioration in investor confidence? 

I heard our first panel, whether you agree with them or not, talk- 
ing about another problem that's emerging, as they described it, as 
a result of the system as it presently is working. And yet, you 
didn't seem to reflect that in your testimony, whether or not that's 
a legitimate concern for this committee to he worried about as we 
look at a system here, whether or not we are contributing in some 
way under the present system to the lack of attraction to capital, 
to the difficulty in getting directors, to taking resources and divert- 



51 

ing them into litigation rather than research and development and 
the like, that sort of series of issues? 

Mr. Seligman. Let me offer a few thoughts. 

I did not focus my study over the last dozen years or so, which 
has been writing a long treatise, on the northern district of Califor- 
nia or on a particular industry. Nonetheless, there is a good deal 
of historical data in the experience of the SEC that more fraud 
tends to occur with small growth companies. 

What you had up here this morning was four companies which 
felt that they were victimized. And I want you to note — they were 
all successful companies. There are a lot of companies that fall by 
the way. There are companies that commit fraud. 

It's a particularly difficult problem for the brilliant inventor to 
make the move from the garage to the corporate structure, and 
particularly with concepts such as internal accounting controls 
there have been many instances where there have been meritorious 
lawsuits. 

Now, my concern with the thrust of certain recent legislation 
that has been introduced in both the House and Senate side, in 
this term in the Senate 

Senator Dodd. There's no bill that's been introduced over here. 

Mr. Seligman. I understand. I was going back to the last ses- 
sion — is that if you significantly increase the impediments to litiga- 
tion, you may have a tendency to discourage some small investors, 
not so much because the litigation declines, but because the quality 
of disclosure in the mandatory disclosure system won't have the 
same integrity it otherwise might. 

And there, if I might, I want to highlight that the joint and sev- 
eral liability concepts which have been brooded about some in re- 
cent months in particular, are of particular concern. The account- 
ants perform a very, very significant role in cross-checking the in- 
tegrity of what's prepared by management. If you reduce the finan- 
cial incentive to do so, you may ultimately, to some degree, reduce 
the integrity of what is disclosed. 

Senator Dodd. Mr. McLucas and Mr. Griffin, you both talked 
about and we raised it up here, some of us, the existing tools and 
procedures that are available today to defendants, designed to limit 
frivolous litigation — rule 11, motions to dismiss, and the like. 

We heard from our first panel that they use those tools. And 
some of them, of course, talked about the cases that were dismissed 
and the process. But they also talked about the cost associated 
with that. Even though the outcome was a dismissal, they talked 
about the $500,000 ranges, or $1 million expended in those efforts. 

It seems to me that the SEC ought to be concerned about that, 
to some degree, the kinds of costs that are being expended to have 
to reach that conclusion that the legal process allows them to 
achieve. 

How do you answer those concerns? 

Mr. McLucas. Well, Mr. Chairman, we are concerned. The 
$64,000 question here is figuring out how you surgically deal with 
the lawsuit that is filed an hour after the stock declines five points 
without reasonable investigation because I don't know how some- 
one could do it, and yet, not adversely affect investors with legiti- 
mate causes of action because of actual fraud. 



52 

We do see, and we had terrible experience with the pennystock 
problem. That's not what we're talking about today. But I would 
not come to the conclusion that start-up companies are more prone 
to fraud. However, we have had a lot of experience with companies 
where, in addition to fraud, out and out fraud as we saw in the 
pennystock market and in the start-up companies, there are con- 
cerns about whether the systems, the controls, and the companies 
themselves catch up with the reporting responsibilities that go with 
growth and the kind of growth rate that affect some of these com- 
panies. 

The other phenomenon that I think contributes to the problem 
here is a lot of these companies are high-tech or speculative in the 
sense that people are betting on tremendous successes, the next 
Apple computer or the next biotech company to develop the cure for 
AIDS. 

I would hesitate to tell you that some of the lawsuits that are 
filed may well be the result of investor expectations that have just 
been dashed, not because someone's committed fraud, but because 
the expectations have not been met by the company for legitimate 
reasons. 

The concern we have in getting at it ought to be directed at the 
courthouse door, at frivolous, meritless litigation, trying to reach 
an imposition of cost where it's most effective, but not doing some- 
thing which changes the standards for liability. I think that that 
would be a mistake at this juncture because the data don't support 
some of the proposals that have been bandied about, in my view. 

So the key here is to look at the areas where we might have the 
most positive effect — frivolous litigation, what the penalties for that 
ought to be, perhaps looking at the class-action system and some 
reforms there that may eliminate the perceptions tnat have at least 
been created by some of the stories you've heard today. 

Those are trie things where we think more study ought to be 
done because that may be the place where a surgical fix will be 
most effective. 

Senator Dodd. I apologize, my time is up. Before Mr. Griffin re- 
sponds, let me put a twist on the question as well. 

And again, Mr. McLucas, quoting you here, you said, class-action 
counsel tend to operate in an entrepreneurial capacity rather than 
as a fiduciary operating at the direction of a client. That's a very 
troubling comment from you, given your position. 

Mr. McLucas. Right. 

Senator Dodd. Arid I would like Mr. Griffin to respond to this 
as well. I want to know whether you agree with Mr. McLucas, from 
the State perspective. And having said that, it seems to me there 
becomes a heightened degree — we want a response having said 
that to us here, what do we do about that? 

Mr. McLucas. I did not intend the characterization to be per- 
haps as pejorative as it was taken. 

Most lawyers are in business to make money, except for some of 
us in public service who get psychic income. 

[Laughter.] 

What I intended, Mr. Chairman, was that the way the system 
now works, particularly in class securities litigation, class actions 
under the securities laws, is, unlike where the client walks in and 



53 

sits down with the lawyer, they examine the problem, decide that 
the answer is that we've got to go to court, in these situations, it 
seems to me that the lawyer functions perhaps more as the prin- 
cipal. 

The question of whether there is a cause of action, who the client 
is, what the claim should be, who should be sued, whether the case 
should be litigated or settled, it seems are, for the most part, those 
decisions are all made by the lawyer, which is quite different from 
the situation where you have a real client, and in other class-action 
litigation where your class may be more readily definable and the 
harm that one's seeking to redress may be more of a different na- 
ture. 

What I'm concerned about is that maybe we ought to look at 
whether there's some reformation in that area that ought to be 
done. The number of class actions has gone up. I don't know that 
the data supports the conclusion that there's gross abuse here. On 
the other hand, listening to Ms. Reilly testify, it's troublesome to 
hear an investor who says, I went through tnis process and I got 
8 cents on the dollar. 

Senator Dodd. Yes. 

Mr. McLucas. I don't know that we have answers, but I think 
that's an area where we've got to look at some possible reforms to 
deal with what appears to be a problem in some cases. 

Senator Dodd. OK. Mr. Griffin. 

Mr. Griffin. Mr. Chairman, let me respond to your last question 
first. 

I think that we would all agree that there may be an inherent 
conflict in the attorney-client relationship in class-action suits 
which goes somewhat unchecked by ethical concerns, because of the 
large amounts of money involved, and I share Mr. McLucas's con- 
cern upon hearing Ms. Reilly's testimony. 

To go back to your original question with regard to the delays in 
getting, and the large expenses, in getting to the point where you 
can file a motion to dismiss on frivolous grounds, I think the com- 
mittee also ought to take into account, and not that I'm carrying 
anyone's water here in the plaintiffs' bar, but the committee also 
ought to take into account what incentives defense counsel outside 
these firms have for slowing down the process. And there are eco- 
nomic concerns on that side of the fence which I think contribute 
to the mix of complexity that this committee is presented with in 
dealing with these issues. 

I think that the key to all of this is the judicial function. The 
judges are gatekeepers on these matters and the focus of any re- 
forms that we're looking at ought to be concerned with how the 
judges exercise their discretion ooth in rule 9(b) motions and mo- 
tions based on rule 11 for dismissals, if we can encourage that 
more in frivolous claims. 

Obviously, a grand solution to all of this, but it would be non- 
productive for the Ms. Reillys of the world, is to simply close the 
courtroom doors. I believe I testified that, to some extent, these re- 
forms that we're kicking around here today do just that — they close 
the courtroom doors. They cut off the recovery, however small it 
might be, for the Ms. Reillys. Now, if we can turn up the recovery 
key, I'm all in favor of that. 



54 

Senator Dodd. Thank you very much. Senator Domenici. 

Senator Domenici. Senator D'Amato has to leave. 

Senator Dodd. Yes. 

Senator D'Amato. Mr. Chairman, I have some people who have 
come up from New York. 

Senator Dodd. I appreciate the time you've invested in this. 

Senator D'Amato. Well, let me say, I want to thank Senator 
Pete. I don't know quite how you say that name, either, sometimes. 

[Laughter.] 

Senator Dodd. Two Italians. 

[Laughter.] 

Senator D'Amato. But, anyway 

Senator Domenici. Let me tell you, when I go to your State, the 
Italians tell me that they know how to pronounce my name and it's 
not the way I say it. 

[Laughter.] 

Senator D'Amato. That's true. 

Senator Domenici. I tell them, go to Italy, find my folks there, 
they say it the way I do. But, anyway 

[Laughter.] 

Senator D'Amato. Let me tell you, first of all, Ms. Reilly, who 
came here on her own dime, you're really putting forth some very 
compelling facts. All this other stuff, rule 10(b), rule 9, rule 11. I 
don't know. Scribbling notes, trying to tell me what it means. 

[Laughter.] 

I don't think the judges know what it means. They certainly in- 
terpret it one way in one jurisdiction and another way in another 
jurisdiction. Nobody knows. 

But what is obvious, in that settlement, the only people who real- 
ly did anything were the lawyers. And they did pretty well. 

You can tell I don't practice. 

[Laughter.] 

It seems to me that the insurance companies also have sold out 
and taken the easy way out because if every time they knock at 
the door, you feed the wolf, the wolfs going to come back. 

And so where you don't have meritorious cases, you should liti- 
gate them. Knock them out of the business. Fight 'em. That's not 
going to make me too many friends in the insurance industry, but 
I don't make friends wherever I go. 

[Laughter.] 

That s really what you should do. If you have a lousy case, screw 
'em. Fight 'em, and we'll see how long that big, tough company, 
which is really a company of lawyers that have come together and 
found this pot of gold, because I have to tell you something. And 
Dr. O'Brien, your studies really hit the nail, and the guys at the 
SEC ought to take a look at it, if indeed, when they bring these 
actions, the shareholders are getting 1 percent, 3 percent. 

Here you have Ms. Reilly who testifies vividly, out of all of this 
money, where it goes and stockholders wound up getting this teeny 
little bit, and the lawyers are dragging it off. And you've got judges 
that are even going above and beyond the billable hours, rewarding 
them. What, are we kidding? So maybe that's something we have 
to do there. 



55 

It seems to me that what we have is a situation where this is 
a terrific industry to get involved and to bring these suits because 
you've got the insurance companies that are going to pay you at 
some point and the stockholders and shareholders don't get any- 
thing, as a practical matter. 

So you have these suits brought. The shareholders get little, if 
anything. The only people who are getting it are the litigators, and 
99 percent of the times, they're not even litigating, as Dr. O'Brien 
says, and the cases are being settled. It's just wrong. And what 
you're going to do is you're going to make it difficult for small com- 
panies that do need the insurance to get it where they could be- 
cause they're going to have to pay higher prices and you're going 
to just continue this evolution. 

I don't know, in the Doctor's statement, you have one out of eight 
companies being sued regularly. We'd have to take a look and see 
if we can reconcile all of that with the numbers we have here. But, 
certainly, I would think that we've got to look at this in some way, 
and I'd like to see our people over here, the SEC and some others, 
come up with some ideas as to what to do, and maybe place some 
limits on this situation. 

I think that's what Senator Pete is trying to do. We're not trying 
to take away the stockholders' rights. We want to see that they're 
really going to be protected, and that this isn't just an opportunity 
for those in the legal area to come in and, if they found a nice situ- 
ation, and cream the carriers. That's wrong — and the people, and 
stockholders, they really don't care about you. 

You gave a perfect example. That's not what the system is sup- 
posed to do. So I would hope that we could do something, and I 
want to commend the Chairman and Senator Domenici for calling 
these hearings. 

I thank you for giving me the time to make this little observa- 
tion. 

Senator Dodd. Thank you, Senator. 

Senator Domenici. Senator. 

Senator Dodd. Yes. 

Senator Domenici. Mr. Chairman, let me also thank Ms. Reilly. 
I think we hear a lot of information, but it's very good to have an 
actual, what I consider to be a victim. You were victimized in all 
respects. You were victimized after you became a plaintiff and the 
case got settled. You were victimized before it, apparently. 

I'd like Professor Seligman to share with me on this, Professor, 
I think one of the things that's being missed is that we are equat- 
ing a court of law with potential jury verdicts as a new instrument 
of regulation. Frankly, that's part of the problem across America. 

The court and the jury system is not a regulatory system. It is 
a devastating system. You get one verdict for $150 million in one 
of these cases and it becomes the threshold for, what? For regula- 
tion, because now all suits get valued that way. 

Now I don't know if there are 289 or one out of eight on the New 
York Stock Exchange that are getting sued. But I think what we 
have to come to is we have to begin to question whether lawsuits, 
litigation and jury verdicts are the way to resolve these kinds of 
issues day in and day out, or are they the extraordinary way? 



56 

I tell you, I believe — I went to law school a long time ago, also, 
and incidentally, for the lawyers here, I only have three children 
in my family who are lawyers and I'm telling the other five, 
"please, don't be lawyers." 

[Laughter.] 

Three out of eight children turning into lawyers is enough for 
any family. I told the others, go work, so maybe you can earn some 
money for the lawyers. 

[Laughter.] 

But, in any event — and incidentally, Dr. O'Brien, one of those 
lawyers just graduated from Harvard Business School with the 
same degree you have. She did OK I don't know where she fits in 
all this. 

When we say we don't want to shake away investors' confidence 
we seem to be saying, litigation contributes to this confidence. It 
seems to me, Professor, you have to ask the question, "what else 
is litigation doing?" Litigation is not a regulatory scheme. It's the 
"what else" litigation that's causing a critical issue before this com- 
mittee. 

I now hear Mr. McLucas, after you hear Ms. Reilly testify, that 
you're saying, well, maybe we ought to do something about it. 

Let me tell you, if you are not aware of the thousands of Ms. 
Reilly s out there, you aren't doing your job. You shouldn't have to 
come here to hear her talk about it. This is a topic that everybody 
writes about. This fact pattern is right there. It seems to me that 
the SEC should have been here today saying what Pat Reilly said 
because it's true and it's not just anecdotal. Now having said that, 
let me lay before you, Professor, my thoughts about the balance. 

Frankly, when the common law of England came to America and 
we embraced the right to a trial by jury, I'll tell you, our fore- 
fathers would get out of the grave and march on the court system 
if they thought we were going to be settling these kinds of cases 
in ordinary courts with ordinary juries. 

That's my own observation. It's nothing more than mine. But I'll 
tell you, it gets very pervasive when the settlements are all based 
upon the threat of what a jury might do. For any big popular com- 
pany that's out there and they're moving along and they've got 
three or four of these going, and it's pervasive in the society. 
_ If you think we're going to get big accountants and auditing 
firms the next decade without some change in this law that are 
going to be around as experts as they have been in the past 40 
years that made America business-great, then go out and ask about 
it. They're already disappearing. The people that want to be audi- 
tors, the diminished number is extraordinary. 

Who wants to be in this profession? They have 1-hour's worth of 
work on one of these audits and they're sued and they're as liable 
as the president of the company that did perpetrate the fraud. I 
think some of them can't buy insurance. You know that. Isn't that 
important? 

I'll tell you, I'll close with this and then I'll get your observations 
and Professor, I'd like yours on the philosophy that I expressed. 

Mr. Seligman. Sure. 

Senator Domenici. I want to put in the record a letter written 
to Senator Sanford and Senator Domenici last year, dated August 



57 

12, by then -Chairman Breeden. He sounds a little different than 
you today. Maybe he's the chairman and you're representing some- 
body else. But this letter says it's time to change. In fact, he even 
says, one way to get around the frivolous filings may be moving to- 
ward the English rule, not totally, but somewhat. 

He also suggests that joint and several liability ought to be 
changed. That s his, in writing, because he sees some problems out 
there. Now that's all I'm here for. I see some problems. I don't have 
all the answers, and the problems may be much smaller than I see 
them. But what I've expressed is a genuine concern. 

So now let me yield to you, Professor, and then we'll go right 
around. Anybody that has some comments, I'd like to hear them. 

Mr. SELIGMAN. Senator, I have no question there are some prob- 
lems. And they're real. There's no question that they're there. But 
they have to be seen against a trillion-dollar economy with over 
13,000 corporations subject to the SEC's jurisdiction, in a cir- 
cumstance where the SEC, at most, can bring about 10 percent of 
the litigation that is brought in the Federal system. 

The Supreme Court, as early as 1964, implied a cause of action 
under rule 14(a)(9) because the court recognized the SEC could not 
carry the full load in this area. 

Now, implicit in your concerns and they're genuine and they're 
real and they're important ones, I think is a question that's worth 
you struggling with a little bit. And that is, there is some real 
fraud out there, too. When $700 million is recovered in litigation 
from the Washington Public Power Supply System, that gives me 
concern. It's not the only jury recovery of substantial amounts that 
we've seen in recent years. 

Second, I think it's worth bearing in mind that what we're most 
concerned about when we look at litigation is insuring the quality 
of disclosure that will give investors confidence they can safely in- 
vest. And it's at that level, which is difficult to draw data on, that 
I think the most important issues are suggested. 

If you go back before there was an SEC, we didn't have a full 
disclosure system. If you go back before there was an SEC, you had 
rampant puffery and fraud and you basically did not have a court 
system that could effectively address it because of the court-made 
doctrine of privity. 

Under the SEC securities laws, as enforced both in governmental 
and private lawsuits, we've developed some deterrent punch. And 
the real significance of it, I would submit to you, is not that occa- 
sionally shareholders recover money, but that it causes corpora- 
tions to hire good accountants and good law firms. 

It causes corporations to design internal systems of accounting 
control so that they avoid fraud. It's the avoidance of fraud, it's the 
honest disclosure that's the benefit that stems from the system 
that we now have. 

My concerns, Senator, when we talk, whether it's concerns about 
joint and several liability or the English rule, is that if these were 
put into effect, there would be so dramatic and radical a change in 
the current system, we would reduce our ability to be confident, 
then when corporations make disclosures to the investing public, 
they would be reliable. 



58 

Senator Domenici. Well, I appreciate your reasoning. I have 
great respect for you. I know somewhat of your history and your 
reputation. 

I do suggest that you can change the system without the cause 
and effect being less credibility and less honesty. 

The joint and several liability aspect is a bird's nest for claim- 
ants. It's a creature of our own law. It's not a creature of security 
or of trust or of reliance. It's a creature of a joint and several con- 
cept that grew up in American litigation and we apply it here. 

So I am for change, and especially where it seems to me it will 
do exactly what you want done. You're going to get better auditing, 
better disclosure, and better firms if the system provides propor- 
tionate liability in appropriate circumstances instead of joint and 
several liability. 

Right now, you're getting very poor response. But let me ask Mr. 
McLucas. 

Mr. McLucas. Senator, let me clarify, first of all, on Ms. Reilly. 
My reaction to her testimony is as to what she described to you as 
the recovery she received in a class-action system. 

Neither the SEC, nor I, have any role or control or input over 
those settlements. They are court-approved, including the court-ap- 
proved fees. There's nobody in the room more concerned about re- 
covery for individual investors than I am. 

In the last 6 or 7 years alone, we have gotten probably a billion 
or $1.2 billion in recovery for investors, every dime of which went 
back to investors and not to the lawyers, because we don't permit 
lawyers' fees to be taken out of our disgorgement funds. 

So my concern really is with the system. But it is not a system 
that the SEC has direct jurisdiction over or input on when a class 
action or private action is settled. 

Second, let me say a few words on joint and several liability. I 
have obviously read that letter very carefully. 

Senator Domenici. Even if you don't have control, you have con- 
cern over that issue that she raised, don't you? 

Mr. McLucas. Absolutely, sir. 

Senator Domenici. And that's all I was raising. 

Mr. McLucas. And that's why we have some suggestions in our 
testimony about reformation of securities class-action litigation and 
some suggestions about, if this is abusive, the litigation, an ability 
to shift fees where a court decides that it's meritless, in the first 
place, and put the fees on the lawyers. 

Let me say a few words on our position on joint and several li- 
ability. Obviously, I have read the letter that former Chairman 
Breeden wrote very carefully. 

If you look at the data even that the accountants have submitted 
to the subcommittee, the real problem here, at least the way that 
I look at the data, Senator, is liability under State laws that permit 
joint and several liability on the basis of negligence alone. 

We have expressed in our testimony the view that, as to that 
standard, imposing joint and several liability may indeed be inequi- 
table and it may be excessive and that perhaps there should be 
some apportionment of liability according to one's level of wrong- 
doing or inattentiveness. 



59 

The difficulty under rule 10(b)(5) with joint and several liability 
and limiting it is the following. 

before you get to the issue of apportioning liability, to even be 
found culpable in rule 10(b)(5) action, you have to either have acted 
with sienter to have committed a fraud, or to have acted in what 
is called reckless disregard of the ordinary standards of care. 

Our concern is, in the worst cases where investors lose every- 
thing, the company is bankrupt, there is no one left standing, as 
between defrauded investors and someone who is found to have 
aided and abetted a fraud, I come down on the side of the investors 
and say that it would be a serious matter at this juncture to start 
changing the standards of liability. I am uncomfortable that we 
know enough now to say that that is the correct course or direction 
in which to go. 

Senator Domenici. I understand that rationale. Obviously, that 
should be of great concern. 

However, frequently, we have to look at the facts and the facts 
are that the predominance of these cases are all settled (97 percent 
settlement rate compared to 60 percent or 70 percent settlement 
rate for other types of litigation). This means we don't have your 
situation and the settlement is coming from everybody involvea, in- 
cluding the package of joint and several liability and the insurance 
coverage. 

I do want to say for the record, not that I need to, but I should 
have said it when Senator D'Amato was here, but the notion as a 
lawyer — we have some lawyers here. They were probably thinking 
the same thing. When you say an insurance company should not 
settle, they should fight to the death. All litigators have done that. 
Even in my 8 years of practice, I stuck the insurance company for 
the whole verdict because they didn't settle within policy limits. 

We know that. If somebody says, look, we've got $30 million 
worth of insurance and we want to try this lawsuit. You'd better 
settle. The insurance company goes to that trial at its risk. If $150 
comes, they've just had an expansion of their coverage. So every- 
body knows that and that's how they get the limits. 

Let me make the letter from the former chairman a part of the 
record, could I, Mr. Chairman? 

Senator Dodd. We'll receive that into the record. 

Senator Domenici. Let me say to our friend now from the SEC 
one further thing. 

I think we have the significant number of States' statutes that 
allow proportionate liability and another group of States that ad- 
here to joint and several liability for accountants. And I think it's 
about a third, two-thirds, from what we've been told. 

Mr. McLucas. The data that the accounting firm submitted, and 
it's not clear. Thirty percent of all of the claims that the accounting 
firms have been subjected to are claims where rule 10(b)(5) is a 
part of the action. But only 10 percent of that 30 percent is a case 
where the claim is solely rule 10(b)(5). 

And that's why I indicated, Senator, my conclusion was that the 
real guts of the problem here is the issue of joint and several liabil- 
ity under State liability laws where negligence is the standard 
rather than fraud. 



76-761 - QA _ -3 



60 

Senator Domenici. I would say, Mr. Chairman, not that I want 
to dredge up past language, but in an effort to resolve this, when 
we were working with your former chairman, we had a two-tier li- 
ability scheme which would have even taken care of that case you 
were worried about because the real bad players who initiate the 
fraud knowingly would remain liable under the joint and several 
requirement. 

It's in the other situations that proportionate liability would be 
the rule. And I think you've reviewed that as you looked at the 
former chairman's comments. It was in his file. 

Ms. Reilly, do you have any comments on what I have said? Does 
anything come to your mind that you want to put on the record? 

Ms. Reilly. Well, what I'd like to expand on are a couple of 
things and that's in the area of solutions, possible solutions. 

Senator Domenici. Great. 

Ms. Reilly. My proposal is that the attorneys receive as their 
fees, since I think these suits are really fee-driven, that they re- 
ceive as fees the same percentage of the settlement that we recover 
of our losses. 

My thought, they're used to getting 25 percent. We're used to — 
you've heard my case and you've heard what Dr. O'Brien has said. 

Now if the lawyers wanted to maintain their standard of fees at 
25 percent, then they'd have to get 25 percent for the shareholders. 
They would then go to the defrauding defendants and say, OK, we 
need 50 percent to settle this. 

They won't settle. And so, it then forces it back — my assumption 
would be that the defendants then won't settle. Why settle for 50 
percent? If you can buy off the suit at 6 percent, which is what I 
think they're doing, why take the chance? Whether there was fraud 
or not, take 6 percent and get out of here. 

If, instead, our attorneys went to them and said, we have to have 
50 percent to settle because we've got to get our 25 percent and we 
only get our 25 percent if our clients get 25 percent, suddenly, the 
defendants aren't going to settle and they'll say, hey, we'll take it 
to trial. Rather than pay you 50 percent, I'd rather gamble. I'd 
rather go to trial on it. 

See, everybody seems to think settlement — settle, settle, settle. 

Let's go to trial. Now this might go against these massive judg- 
ments that you see, but I think then what happens is if the threat 
of a trial actually were hanging over our lawyer's head, you'd see 
less suits filed because now they'd have to go and prove their fraud. 

And as a stockholder, I'm not interested in extorting money from 
companies who didn't commit fraud. I don't feel like I want to be 
part of a scheme and get a couple of pennies for this whole thing. 
I don't need that. On the other hand, if I have been defrauded, and 
that's why I lost money, I feel those people should be held account- 
able. 

In the case of Tucson Electric, none of those people put up a 
dime. The officers left and they brought in new management. That 
CEO was making over $1 million. He is long gone. 

At the hearing that we had at Tucson, where the stockholders 
showed up, there were many of the stockholders that were quite 
upset saying, what's going to happen to these officers and direc- 
tors? 



61 

And the judge, by the way, another problem that I see with this 
system is that the judge only gets his information from the plain- 
tiffs' attorneys. There were about 30 shareholders at this hearing. 
The hearing lasted 15 minutes. We were on and off. He made his 
thing and boom, boom, thank you very much, and the settlement 
was approved. Instead of giving the lawyers $9 million, they got 
$7V2 million. He did his perfunctory thing of saying to the share- 
holders, thank you for talking to the court, and the settlement was 
approved. The hearing was over. 

So the other thing I feel, and I raised this point at the judge, an- 
other solution I feel is that the stockholders should be informed of 
how little they're going to get out of these cases. 

The notice, which I've got here, in Tucson Electric says that we're 
getting $30 million. Now I lose $5,500. $30 million compared to my 
$5,500 is a lot of money. So you think, well, maybe I'll get my 
money back. 

The other thing that's in the notice says that this settlement will 
confer a substantial benefit to the class and each of the members. 
If there's a deception, I think there's a deception by our attorneys 
in misleading the stockholders into thinking, one, the settlement is 
for $30 million and it's going to confer substantial benefit. What 
would you, as a stockholder with a $5,500 loss, think? You would 
think that you were going to get a big chunk of your money back. 

Now the plaintiffs' attorneys don't tell you in the notice how little 
the stockholders are going to get because if they did, the stockhold- 
ers wouldn't accept these settlements, and they certainly wouldn't 
accept paying them those kinds of fees. 

So I feel a couple of things. One is you limit the percent that the 
stockholders recover — I'm sorry. You limit the percent that the at- 
torneys recover from the settlement in proportion to what the 
stockholders recover, if it's based on the insurance. 

If it's based on — let's say in the case of Tucson Electric, they 
could have only gotten a few hundred thousand from the defraud- 
ing officers and directors. Well, they can't reimburse the stockhold- 
ers, and so we're not going to get much out of it. But at least we 
would have felt that we got a sense of justice out of this, if the peo- 
ple who committed the fraud had been held accountable. OK I 
don't get my money back, but at least somebody who caused us to 
lose the money was held accountable. 

Well, in that case, if you want to give the lawyers 25 percent of 
that, or whatever, that's fine. I'm not saying limit it to that. But 
when the money is coming from insurance, where nobody's held ac- 
countable and we don't recover much, where we get 5, 6 percent 
of the dollar of losses, then I think that the attorneys' fees should 
be 5 or 6 percent of what the settlement is. And I believe that will 
result in truer cases of fraud being brought and that people are 
held accountable and that these cases where there isn't fraud, if 
they're just to extort legal fees, that those won't happen. 

Senator Domenici. I thank you very much, ma'am, for your sug- 
gestions and your frankness. 

I would want to tell you, my concern is not about the big jury 
fees or big jury verdicts. My concern is actually what you're talking 
about, that one big verdict increases the stakes for all future settle- 



62 

ments. It sets a threshold for the settlements. And if I expressed 
it imprecisely, that's what I meant. 

You raised the very issue of this disproportionate settlement 
number, the proportion of them that are settled. Is there some rea- 
son for that? Everybody says that that's inordinate in the tort sys- 
tem and inordinate in the civil liability lawsuits that are filed. 

Now I didn't mean to cut anybody short, but I will close, Profes- 
sor Seligman, by saying that I hope you understand that I'm abso- 
lutely convinced that we can do a better job on meritless lawsuits, 
getting rid of more meritless lawsuits at less expense to companies 
and stockholders, and yet, punish the true culprits and protect in- 
vestors. 

I am not seeing a great relationship between the true fraud cases 
of this country and what I am being told are much of these 
boilerplate lawsuits that are being filed. 

So I thank you nonetheless for your observations. 

Senator Dodd. We've got a vote. I'm going to ask one last ques- 
tion and then excuse this panel and come right back and pick up 
with our last panel here. 

I guess I'd address the question to the three of you, if I could, 
Mr. Griffin, Professor Seligman, and Mr. McLucas. We've heard it 
suggested here that as a result of the complaints we're hearing 
about, we're going to potentially get less disclosure, which is abso- 
lutely the opposite direction we want to go in. People are saying, 
well just disclose less and sort of minimize the possibility of law- 
suits. 

The other side is we're getting, at least from these accounting 
firms, some of them suggesting, well, we're just not going to get in- 
volved with these smaller firms out there where some of you have 
suggested some of the more problems are for the very reasons 
you've identified. 

We get fooling around with those guys and then, of course, we're 
only going to get in trouble ourselves, at a time when we want 
them to be utilizing professional accounting firms so that they'll 
succeed, one, but also minimize the possibility of fraud. 

I wonder how you respond to that concern, that in fact, the very 
process, the very goals we're trying to achieve under the present 
system seems to discourage that — more disclosure, hiring profes- 
sional people who will assume the responsibility of assisting these 
smaller firms 

Senator Domenici. Good point. 

Senator Dodd. If, in fact, we're driving them the other direction, 
something's wrong here, it seems. It at least would appear to me. 
Why am I wrong in that thinking? 

Mr. McLucas. Well, on the latter point, on the accounting issue, 
I am not convinced that there is a problem of the dimension with 
respect to the accountants that you've been led to believe. 

I think it's fair to ask how we had the hundreds of banks and 
thrifts that failed with an insurance bill, the current estimates, as 
I understand it, are between $160 and $180 billion, and that 
doesn't count the shareholder equity that was totally wiped out, all 
by institutions that had clean opinions and certified financial state- 
ments? 



63 

I think the profession does a good job. One of the reasons we 
have the strong capital markets we have is the strength of the ac- 
counting profession. But I don't think the accounting profession can 
say that there has not been a problem. 

Senator Dodd. I don't think they're saying that. 

Mr. McLucas. Well, what I don't believe that you ought to con- 
clude from what they're telling you is that they're not going to go 
and take on the business from emerging or growth companies. 

There may be some data to indicate they are doing more careful 
risk analysis and risk assessment. But the answer to that ought to 
be better auditing, clearer accounting principles, and more effective 
quality control by the auditors, not changing the laws of liability, 
so that if there is a fraud, they are a special class of professional 
that will be able to walk away from it. The answer is better audit- 
ing standards and better accounting principles and better quality 
control. 

Senator Dodd. What about the first point? 

Mr. McLucas. I'm sorry? 

Senator Dodd. Disclosure. 

Mr. McLucas. The issue of disclosure. I think that there is al- 
ways a concern by companies about how much you say in the area 
of projections and MD&A and how much do you tell the analysts 
and how much investor expectation do you create. I don't have an 
easy answer for that. The SEC has struggled to balance the need 
for effective and quality disclosure with getting rid of the idea that 
reams and reams and reams of more information is going to make 
the market more efficient. It doesn't. 

What we need is a system that encourages frank and candid and 
honest disclosure and we need to look at what's happening with 
rule 11, look at what's happening with the motions to dismiss and 
the data the accounting firms have submitted indicates that they're 
having much greater success having these cases thrown out, and 
look at the possibility of appending a fee-shifting provision to rule 
10(b)(5) that may do more to put the risk of frivolous litigation or 
meritless litigation on the lawyers that are bringing the com- 
plaints. 

Senator Dodd. Any of you want to comment on this? 

Mr. Seligman. If I could make a brief comment, then I'd like to 
be excused for an airplane. 

Senator Dodd. We'll see. 

[Laughter.] 

I let Senator D'Amato go. I'm not going to necessarily let you go. 

[Laughter.] 

Mr. Seligman. First, the accountants aren't going to quit the 
profession with small start-up companies. They may make cost ad- 
justments, but they want small start-up companies. They're going 
to be big companies and they're going to be good clients. They're 
not going to leave. 

Second, the observation was made that you may see a diminution 
in projections. To the extent you have discretionary projections now 
under some SEC items, only about 10 percent of the firms make 
them anyway. It's hard to see why there would be significant 
changes. 



64 

Third, with respect to a fee-shifting idea along the lines of sec- 
tion 11(e), I would urge you to take a good look at the case law 
there. I think you'll discover that there aren't meaningful dif- 
ferences between the results under section 11(e) of the Securities 
Act of 1933 and rule 11 of the Federal Rules of Civil Procedure. 
You're not going to add much if that's the fee-shifting proposal that 
you've got. 

I would also urge you to take seriously Mr. McLucas's suggestion. 
If you look at the increase in the number of successful rule 11 mo- 
tions, and if you look at it over time, you will see there has been 
a significant increase in the last few years. And if you go further, 
you'll discover that there also is likely to be a high correlation be- 
tween that increase and jurisdictions such as the northern district 
of California with the type of start-up companies that you've clearly 
evinced real concern about today. 

Senator Dodd. Mr. Griffin. 

Mr. Griffin. Senator Dodd, I can endorse what both my col- 
leagues have said on this point. 

I might point out by way of projections that - 

Senator Dodd. Thank you very much, Mr. Seligman, for being 
here. We appreciate it immensely. 

Mr. Seligman. Thank you. It's been a pleasure. 

Senator Domenici. Thank you very much. 

Senator Dodd. We may have some written questions for you. 

Mr. Greffin. When we talk about increased disclosure and pro 
forma projections and the like, we may be actually encouraging 
wilder projections and projections that may be unreliable as well 
if we diminish the responsibility of those making the projections. 

That's one observation. I want to go back briefly to a point that 
Senator Pete mentioned. 

Senator Dodd. You're getting familiar around here. 

Mr. Grdtfin. The States recently were successful in intervening 
in a pennies-on-the-dollar class-action settlement. It was a huge 
class-action settlement in Louisiana. We asked the judge to recon- 
sider, becoming the only advocates against the settlement. And in- 
terestingly enough, the judge listened and refused to sign the set- 
tlement pending further study. 

So regulatory agencies do have, or at least are exploring the pos- 
sibility of input into the judicial process in order to nalt the abuses 
that Ms. Reilly has testified about. 

Senator Dodd. Thank you very much. And we thank all of you 
for being here. 

Do you want to comment on this? 

Dr. O'BRffiN. No, no, I don't. 

Senator Dodd. We're going to miss that vote if we don't leave. 

You've been very, very helpful, all of you, and there may be some 
additional questions. We'll take a temporary recess to go vote and 
come right back to our last panel. We thank them for being patient. 

[Recess.] 

Senator Dodd. The subcommittee will be reconvened. 

First of all, our apologies. We had, I think, three or four votes, 
I guess, back to back there, so we apologize to all five of you here. 
Frankly, the panels went on a little longer, but part of it was the 
interest of our colleagues. 



65 

Normally, we have one or two people. And the fact that we had 
five, six, seven people here off and on stretches those processes out. 
So we apologize to all of you and we thank you immensely for being 
with us today. 

Let me quickly turn to our panel here. 

Mr. Bill Lerach from San Diego. I'd be remiss if I didn't point out 
for the record that he happens to be a good friend of mine and I 
appreciate immensely your presence here today to participate in 
these hearings. 

Mr. Gordon Billipp— did I pronounce that correctly? 

Mr. Billipp. That's right. 

Senator Dodd. Mr. Billipp, we thank you. You're from Jaffrey, 
New Hampshire. 

Mr. Billipp. Yes, sir. 

Senator Dodd. We thank you. You're the fellow who pointed out 
that I wasn't using my microphone back there today. 

Mr. BlLLD?P. That's right. 

Senator Dodd. And I thank you for that observation. I've never 
been accused of that before. 

You're going to introduce yourself? You're David Guin? 

Mr. Guin. I m David Guin. I'm not a witness today. I'm the attor- 
ney for both 

Senator Dodd. Would you please use your microphone because if 
you're not, Mr. Billipp is going to get all over your case. 

[Laughter.] 

Mr. Guin. I'm David Guin, G-u-i-n. I'm not here to testify. I am 
the attorney for both Mr. Billipp and Mr. Ramser. 

Senator Dodd. OK. Fine. 

Mr. Guin. I'm here with them. 

Senator Dodd. Thank you. Mr. Russell Ramser, Jr. I have down 
here Maram Energy Company, Mount Vernon, OH. 

Mr. Ramser. Yes, sir. 

Senator Dodd. OK. And Mr. Edward Radetich. Is that how you 
pronounce that? A CPA, president of Heffler & Company, Philadel- 
phia, PA. 

Mr. Radetich. That's correct. 

Senator Dodd. Mr. Radetich, we appreciate your presence here. 
We'll have that clock on and we ask you to try and move along. 
Again, I don't hold you to it religiously, but to the extent you get 
some sense of your time we can have a good discussion. And again, 
I'll say it because you may not have been here and heard it. All 
of your supporting evidence that you would like to have a part of 
this hearing will be included. 

Bill, thank you again for being here with us. 

Senator Domenici. Mr. Chairman. 

Senator Dodd. Yes, Senator Domenici. 

Senator Domenici. Might I just share with you and with the wit- 
nesses a problem I've got. 

I'm going to be here until 3 p.m. We are going to do 602(b) alloca- 
tions, in the Appropriations Committee. We're going to give each 
subcommittee the entire funding allowance for the next year. I 
have a little interest in that. 

Senator Dodd. How are we going to do on this subcommittee, do 
you think? 



66 

[Laughter.] 

Senator Domenici. Well, we aren't going to get anything. We're 
looking at the other committees that are appropriating and we're 
just here to do other things. 

But, anyway, if we go on beyond that, I'll come back. And if not, 
I will submit additional questions. But I want everybody to know 
that I'm interested and somewhat familiar with wny you're here 
and what you might say. 

Thank you, Mr. Chairman. 

Senator Dodd. Not at all. 

Bill. 

STATEMENT OF WILLIAM S. LERACH, SAN DIEGO, CA 

Mr. Lerach. Chairman Dodd and Senator Pete Domenici, thank 
you for the opportunity to appear before you. 

I am a lawyer that specializes in prosecuting securities class-ac- 
tion lawsuits. I will make every effort to stay within my 5 minutes 
today. But if I go slightly long, I hope you 11 indulge me because 
much of what was said by the first four witnesses who appeared 
here today was said about me indirectly and about cases with 
which I think I have additional information the committee will find 
helpful in evaluating what to do on this contentious subject. 

I am the past president of an organization of some 100 law firms 
throughout the United States that participate in prosecuting secu- 
rities class-action cases, and I speak not only on behalf of them, 
but on behalf of the literally millions of claimants who have re- 
ceived payments out of these cases over the years. 

Obviously, I believe that some of the legislative reforms that 
have been discussed and this committee may shortly consider are 
not only unfair, but unnecessary. And much of the criticism that 
was leveled earlier today was leveled with what I thought was ex- 
cessive rhetoric, with words like extortion and strike suit used very 
frequently. 

I do not want to respond in kind. I want to try to respond with 
factual information that I think will be helpful to you. 

It was said frequently that every time a stock goes down 10 per- 
cent, a securities class-action lawsuit is filed. Please use your au- 
thority and oversight of the SEC to ask them to study that asser- 
tion and obtain objective data. It will prove that that is not the 
case. It is not enough to file a lawsuit that a stock goes down in 
price. Such cases would be immediately thrown out of court. 

You know, Senator Domenici, I watched you as I heard the four 
corporate executives testify and I thought to myself, if all that hap- 

Eened in those cases was what those gentlemen said, I too would 
e enraged. But remember as a lawyer, there's an old saying — 
every suit is an outrage to the defendants named, for every man 
is innocent in his own eyes. There's often two sides to the story. 
For instance, with respect to Adaptec, and I have great respect 
for that immigrant-entrepreneur who has built that company and 
added jobs and I do respect him. But there's more to the story than 
was presented. 

That lawsuit was only filed after the company was forced to re- 
tract an earnings forecast only 2 weeks after it had been made and 
Barron's magazine wrote about that, but for a whole group of 



67 

shareholders, they were plainly disadvantaged by the company's 
action and accused the chairman of selectively disclosing the bad 
information to favored analysts and not the market as a whole. 

And there was more to the case than that. I'll do my Ross Perot 
imitation with a small chart, but we have copies of these for the 
committee. 

In addition to the criticism launched by Barron's, it turned out 
that Mr. Adler had sold 153,000 shares of his stock for $3.2 million 
in the low $20's just before the stock collapsed to below $10 a share 
when the earnings forecast was later retracted. And he was not 
alone. Other insiders sold millions of dollars of stock in addition to 
what he sold. 

In addition, I think that Mr. Adler probably is not all that famil- 
iar with the litigation that is going on. He was asked by Senator 
D'Amato — isn't it true that this case could have been dismissed if 
it was just these generalizations that you complain of? And he said, 
"no, they hadn't made a motion to dismiss." But, in fact, his com- 
pany did make a motion to dismiss, and I have a copy of the court's 
order from the northern district of California on July 10, 1991, 
holding the court finds the plaintiffs' allegation of financial fraud 
more than meet the particularity requirements of Federal Rule of 
Civil Procedure 9(B). 

So I don't think it was quite as one-sided as he presented, and 
also so that you will know, a Federal judge fully familiar with the 
evidence in that case, who is now supervising settlement negotia- 
tions, has recommended that the case be settled for several million 
dollars. 

Let me turn briefly to EMC and Mr. Egan. Again, the case 
wasn't just based on the fact that there was a drop in the stock 
price and some disappointment. The truth of the matter is that in- 
vestigation revealed again that Mr. Egan had shown remarkable 
market timing in selling 465,000 shares of his stock into the mar- 
ket for $5.3 million, at the high point the stock reached during the 
class period, right before the horrible news came out and the stock 
plunged in half. 

He had an opportunity to persuade the judge in that case that 
it was a frivolous lawsuit. They made such a motion. The motion 
was vigorously briefed and argued by competent lawyers and the 
judge decided that the case, while it was dismissed, was not frivo- 
lous. 

Finally, Intel. Intel would have you believe that they were sued 
because they failed to read a Federal judge's mind. The truth of the 
matter is that Intel was sued when its stock plunged over 20 points 
in a few days when a Federal judge in San Francisco ordered a new 
trial to overturn a jury verdict in Intel's favor in a highly pub- 
licized, widely followed lawsuit in which Intel had accused AMD of 
stealing its technology. 

After Intel got that jury verdict, its stock doubled in price in 6 
months. And what happened was Judge Ingraham found that dur- 
ing that trial, Intel, and this was proved by clear and convincing 
evidence, that Intel had obtained the verdict through fraud and 
misrepresentation by concealing from the court material evidence 
in support of AMD's position. 



68 

Thus, the judge vacated the favorable jury verdict and the stock 
collapsed, as it had doubled in light of the favorable information. 

Now another claim that is frequently made is that there has 
been an explosion in class-action cases that has harmed capital for- 
mation. 

Let's look at the objective numbers that are available. This is all 
submitted in my testimony in detail. This is a chart that shows the 
number of public offerings and the proceeds 

Senator Dodd. Bill, where does that come from, the data? 

Mr. Lerach. This data comes from a data base available in the 
securities industry that's in the underlying study. There's no dis- 
pute about the accuracy of these numbers. No one will dispute 
them. 

What they show is that over a 20-year period — well, I don't think 
anyone will dispute the numbers of public offerings or the proceeds, 
your — Mr. Chairman. 

Senator Dodd. I like "your Honor." 

[Laughter.] 

I don t often get called that. 

[Laughter.] 

Mr. Lerach. I'll call you the Honorable Chairman. 

Senator Dodd. There you go, yes. 

[Laughter.] 

Mr. Lerach. These numbers are indisputable. They're a matter 
of objective fact. What they show is that from the early 1970's until 
today, initial public offerings of common stock in this country have 
increased, albeit erratically, have increased a very large amount 
over those years. 

If you look at all common stock offerings, not just initial public 
offerings, you'll see that they too have increased dramatically. 

Compare that, if you will, with this chart. This chart uses official 
figures from the United States administrative office of our courts. 
These are their numbers. You understand that whenever a com- 
plaint is filed in Federal court, a form must go with that complaint 
that identifies what kind of case it is, what statute it arises under. 

And what this shows is that class-action lawsuits in fact have 
been relatively stable over this same 20-year period, despite the 
enormous increase in securities activity. 

Worse than that, please keep in mind that there is significant 
reason to believe that the number of class-action lawsuits shown 
here is overstated; as the man from Intel testified this morning 
that in one instance, he was sued seven times and it was really one 
class action. I believe if you check, you will find that these numbers 
would reflect that as seven lawsuits, when in fact, it was one. 

So class actions have been stable over these years. And these two 
charts I think tell the final story. These compare the relative levels 
of securities offering activities and class-action lawsuits over a 20- 
year period. There's been an explosion in this country all right, but 
it's been an explosion in securities offerings and securities tradings, 
and not in class-action lawsuits, which have been stable over the 
years. 

If I can have one more minute, I just want to respond briefly to 
Dr. O'Brien and Ms. Reilly, my unhappy client. They say that law- 



69 

yers in these cases only recover 5 cents on the dollar of their losses, 
and be careful of the language they used, of their losses. 

The securities laws do not provide a recovery for one's stock mar- 
ket losses. What the securities laws permit a recovery of are the 
damages that are due to the fraud of the defendant and there is 
a dramatic difference between the two. 

Ms. Reilly may well have bought Tucson Electric stock at $30 a 
share and it declined until $10 a share before the fraud occurred. 
We cannot recover that $20 of market loss for her. No law permits 
it. 

We have asked an expert to do a study of the data submitted to 
this committee by Hefler & Company that will testify at the end 
of the table. The expert is from Gilardi and Company, who are the 
administrators of more of these class-action settlements than any- 
one else in the country. 

If you recognize that the recoverable damages in these cases only 
amount to about, on average, 25 percent of the market losses, the 
fact of the matter is that day-in, day-out, securities class actions 
are returning to investors 60 percent of their damages, not 5 cents 
on the dollar, 60 percent, and that's after attorneys' fees. 

And one final piece of empirical evidence — attorneys' fees. I know 
that it's popular to say the attorneys get $3 or $4 million and the 
clients get 3 or 4 cents. But the truth of the matter is that the at- 
torneys only obtain a percentage of the recovery that they make 
and the rest goes to the class members. And what is that percent- 
age? 

Authoritative Class-Action Reports, which has been around for 
years and has done a study of 334 Securities class-action cases over 
a period of like 18 years, has definitive information that attorneys' 
fees and expenses average 15 percent of the recovery, not the other 
numbers that you hear. 

Now it may be that some large cases are involved there and that 
the actual percentage on a more weighted basis would be somewhat 
higher on attorneys' fees. But the attorneys' fees, remember, are 
awarded only by Federal judges, most of whom are relatively con- 
servative today and only after notice to the class. 

Thank you for the opportunity to testify and I hope I can respond 
to any questions that you have. 

Senator Dodd. Thank you, Mr. Lerach. 

Mr. Billipp. 

STATEMENT OF GORDON K. BILLIPP, JAFFREY, NH 

Mr. Billipp. Thank you. My name is Gordon Billipp. I live in 
Jaffrey, New Hampshire. I graduated from Columbia College in 
1943, with a degree in business administration. I served as a naval 
officer in the Pacific in World War II. After the war, I worked for 
Armstrong Cork Company, which is now called Armstrong World 
Industries, for some 24 years. I resigned in 1969. I moved to New 
Hampshire in order to buy a small metal-stamping business. I op- 
erated that business until 1982, sold it, and retired. 

My wife Betty, who is here today, we're part of a sort of joint and 
several household and consequently, she is a party to any invest- 
ment decisions we make, and that's partly why sne's here today. 



70 

She attended Wilson College in Chambersburg, PA, on a full schol- 
arship, class of 1946, majored in English. 

After raising our four sons, she was a successful realtor for about 
12 years, until she too retired. She's just completed a number of 
years of service on the board of directors of a retirement home and 
of a nonprofit community day care center, both of them in Peter- 
borough, NH. 

I have been a director of Vermont-New Hampshire Blue Cross 
and Blue Shield and I am now serving my 22nd year on the board 
of directors of the Granite Bank of Keene and its predecessor 
banks. 

The reason I mention our educational and work backgrounds is 
because we've worked hard for ourselves and our family and our 
community. We are here today because we believe that while the 
legal system may not be perfect, it has worked to provide us with 
some recovery of losses caused by civil crimes committed against us 
and many other bond-holders. 

In 1985, we purchased bonds in a retirement home venture that 
we felt was a good investment, both for ourselves and for an indus- 
try that serves the highest category of citizens in the country, by 
count, the elderly. 

In all, about $17 million of Spartanburg, SC revenue bonds were 
sold to construct and operate a privately-operated retirement cen- 
ter. We bought $20,000 worth of those bonds. However, due to the 
fraudulent activities of the promoters, and those of the legal, ac- 
counting and broker professionals involved, our investment became 
worthless within months of the opening of the center. 

After looking into the cause of the failure, we learned for the first 
time that the developer, a Mr. CD. Stone, was actually a convicted 
felon and that he and the accounting firm had worked together on 
numerous other retirement home deals, almost every single one of 
which had failed. None of this, of course, was disclosed in the pro- 
spectus. 

We also learned that the underwriter, Bob Buchanan of Bu- 
chanan and Company of Jackson, Mississippi, had sold most of the 
bonds by sponsoring free-lunch seminars in retirement homes in 
Arizona and Florida and by falsely representing to the residents of 
these homes that the bonds were 90-percent safe. That's a quota- 
tion. And as safe as U.S. Treasury bonds. 

I have attached a copy of a Forbes magazine article describing 
Mr. Buchanan's unscrupulous sales tactics, and you'll find that at- 
tached to my statement. 

Litigation was our only hope of recovering any portion of our 
money. We filed a class-action lawsuit on behalf of ourselves and 
almost 2,000 other bond-holders in order to recover the lost invest- 
ment. Litigation was slowed down by obstacles engineered by the 
defendants, most of whom were represented by insurance compa- 
nies, and of course, their counsel. 

The insurance companies hired lawyers who seemed to subscribe 
to a theory that the best way to represent their client was not so 
much to address the merits of the litigation, but rather, to overload 
the plaintiffs' attorneys with extraneous briefs and motions, by de- 
manding our personal tax returns for the last several years, by re- 
questing, we felt, completely unnecessary particulars on our own 



71 

private income, our investment history, and our investment prac- 
tice. 

I suppose their purpose was to either dissuade us from continu- 
ing with the lawsuit or to find something that said that we were 
"sophisticated" investors and therefore, we should have known that 
the defendants were, you might say, out to steal our money. In 
other words, as victims, we were to blame for our own misfortune. 

Eventually, most of the insurance companies' lawyers decided to 
settle the case. A large portion of the settlement funds came from 
the accounting firm defendants, who started out with an over $5 
million policy, but could pay only about $750,000 into the settle- 
ment because their own lawyer fees had been paid already and 
prior settlements had been used up from the original coverage. 

When all was said and done, the bond-holders recovered about 
$10 million out of the $16 million they had invested. Although we 
did not recover all of our investment, we were partly vindicated by 
the criminal convictions of Mr. Stone, Mr. Buchanan, and several 
others. We are glad that we received some remuneration and we 
feel that our efforts may have helped to end the careers of a couple 
of fraudulent operators. 

Those gentlemen I just mentioned — I call them gentlemen — are 
presently in jail. 

Maybe there are some things that need to be fixed in our legal 
system. But as voters, taxpayers, and insurance customers and vic- 
tims of fraud, we ask that you not make it more difficult for people 
like us to initiate suits to recover losses caused by fraud. 

If the law had required Betty and me and other bond-holders and 
our lawyers to pay the defendants' exorbitant legal fees if we were 
to lose the case, we never would have stuck our necks out to rep- 
resent the 2,000 investors, many of whom had invested the savings 
of a lifetime. 

I do know that frivolous litigation is sometimes filed. I also know 
that requiring the plaintiff in a securities class action, whose per- 
sonal investment may have been quite small, to assume the risk 
of paying many times that amount to the other side's lawyers, will 
discourage the filing of as many meritorious suits as frivolous ones. 

Had we not filed this suit, I believe the bond-holders would have 
recovered very little, if any, of their investment and Stone and Bu- 
chanan would still be on the streets selling their junk municipal 
bonds instead of serving time. 

I am told that there are criticisms leveled at the age-old principle 
of joint and several liability. But if an accounting firm, a lawyer, 
or other professional willingly associates himself or herself with an 
unscrupulous developer, they should have to pay the full price for 
the consequences of that relationship. 

No one is forced to sell securities to the public. If they don't want 
to assume the responsibilities imposed by law for entering the pub- 
lic securities market, they should borrow the money from a bank 
instead of selling bonds to individual investors. And neither are ac- 
counting or law firms forced to represent specific clients. They 
should choose those clients with care. 

That's really the end of my prepared or written statement, but 
I would like to refer to Senator D'Amato's remarks. At one time he 



72 

said he felt that the judges could be tougher on dismissal motions, 
and I think that is probably a key to this whole situation. 

It seems to me that the legal system provides for the dismissal 
of cases that are considered to be frivolous and the judges, in their 
wisdom, I think, should be able to determine this at an earlier 
stage. 

Second, he mentioned the possibility of a sort of grand jury ap- 
proach to be inserted between the plaintiff and the judge or the 
court. I think that is very appropriate. 

I don't doubt that there is need for some kind of change or im- 
provement in the laws as they stand today. I only urge you not to 
throw out the baby with the bath water. We need protection. It ex- 
ists today and the system works. 

Senator Dodd. I don't think you'll hear anyone up here, Mr. 
Billipp, talk about throwing out the baby with the bath water at 
all. I appreciate your testimony immensely. We'll have some ques- 
tions for you shortly. 

Mr. Billipp. Thank you. 

Senator Dodd. Mr. Ramser. 

STATEMENT OF RUSSELL E. RAMSER, JR., MARAM ENERGY 
COMPANY, MOUNT VERNON, OH 

Mr. Ramser. My name is Russ Ramser. I'm from near Mount 
Vernon, OH, which is near the geographical center of Ohio. I'm an 
engineer and a businessman, a graduate of Ohio State University 
and advanced management program at Harvard. 

Among many other activities, I'm also chairman of an audit com- 
mittee on a national bank. 

From 1985 through 1989, I bought over $100,000 worth of munic- 
ipal bonds to finance the operation of nursing homes in Terre 
Haute, IN, Sullivan, IL, South Beloit, IL, Effingham, IL, Forsyth, 
IL, Atlanta, IL, and Franklin Grove, IL. The issuer of all these 
bonds was First Humanics Corporation, which was represented to 
be a Christian organization devoted to caring for senior citizens. I 
bought the bonds because I needed the regular, supposedly safe, in- 
come for my retirement, and I liked the fact that my money would 
be put to a good use. 

What neither I nor the 4,000 other bond-holders knew was that 
the money we were paying for our bonds was not being used to fix 
up and operate the nursing homes, as had been represented to us; 
it was being used to buy the developer, Lee Sutliffe, a yacht in Fort 
Meyers, Florida. We didn't know and weren't told that Mr. Sutliffe 
was a con artist, who had been caught impersonating a bond law- 
yer for a number of years. 

We didn't know and weren't told that Mr. Sutliffe had been con- 
victed of cheating on his taxes. We didn't know and weren't told 
that the man he hired to run his nursing homes had been run out 
of the State of Florida for providing substandard care to his nurs- 
ing home residents there. And although we were given a long list 
of other nursing home projects that Mr. Sutliffe had developed, we 
weren't told that every one of those projects was a failure. 

I believed what I was told in the prospectuses because they were 
prepared by lawyers who were supposed to be experts in the field, 
and the feasibility studies were prepared by the international pub- 



73 

lie accounting firms of Deloitte & Touche and Price Waterhouse. I 
never would nave imagined that these so-called professionals would 
do business with a man like Lee Sutliffe, had they known of his 
past — but they did. 

In 1989, all of Mr. Sutliffe's nursing homes bankrupted simulta- 
neously. That came as a shock because we had been told in the 
prospectuses that each bond issue stood on its own. If one nursing 
home failed, it would not affect the other homes developed by 
Sutliffe. 

The truth is that the homes were being operated by Sutliffe as 
a Ponzi scheme, and that money being raised on each bond issue 
was being used to pay his personal debts and to pay debts at other 
nursing homes. Sutliffe was robbing Peter to pay Paul. 

A bond-holders' committee was formed in the bankruptcy and I 
volunteered to serve. I was surprised to find out that the SEC has 
no oversight over the municipal bond markets. People like Lee 
Sutliffe do not have to have SEC's permission to sell municipal 
bonds. The only recourse we had was to file a lawsuit. 

When our lawyer filed the suit, the army of defense lawyers — 
who were paid by the hour — began to attack not only our positions 
on the merits of the case, but myself and my family. They accused 
us of filing frivolous litigation and tried to talk the judge into 
awarding sanctions against us. 

They tried to get tne judge to disqualify our lawyers from rep- 
resenting us. Their investigators tried to dig up every little piece 
of dirt they could find on the bond-holders and on our lawyers in 
an effort to scare us into dropping the suit. It didn't work. 

A few months after we filed the suit, the Supreme Court handed 
down a decision that shortened our statute of limitations. Relying 
on the old limitations period, our lawyers had taken 3 or 4 months 
to carefully investigate the merits of the case before filing a law- 
suit. As a result of that Supreme Court decision, our case was dis- 
missed. If our lawyers had not been so careful, the case would have 
been timely. 

I wrote letters to several Members of this subcommittee asking 
that you support legislation to overturn the retroactive effect of 
that Supreme Court decision. And thankfully, you did so. 

After that act was passed, we asked the judge to reinstate the 
case. But the accounting firms didn't care what the Congress had 
said. They argued that your legislation was unconstitutional. The 
judge saw through their bluster and sent our case to a jury. 

In February of last year, we were allowed to try the liability of 
Sutliffe and Deloitte & Touche in a Cincinnati Federal court. 
Deloitte & Touche never offered 1 cent to settle the case before 
trial. But after an 8 week trial, a jury of nine Ohio citizens found 
Deloitte & Touche and Lee Sutliffe guilty of racketeering, Federal 
securities violations and fraud. 

The jury found that Deloitte & Touche knew about Sutliffe's 
past, and knew that the nursing homes were being operated as a 
Ponzi scheme, and conspired with Sutliffe to hide those facts from 
the public. Deloitte & Touche paid us $15 million to settle the case, 
and Price Waterhouse, after seeing what a jury of Ohio citizens 
thought of Deloitte & Touche, paid us another $11,800,000. Sutliffe 
eventually pleaded guilty to securities fraud. 



74 

All together, our lawyers recovered over $46 million for the bond- 
holders. Even after paying attorneys' fees, the bond-holders as a 
whole received approximately 50 percent of their losses. Plus, our 
bond-holders committee hired new management to run the nursing 
homes and most of the homes now are able to pay their bills and 
are paying some of the interest on the bonds. 

I know that it's fashionable in some circles to criticize our judi- 
cial system. But in my case, the system worked. The judge saw 
through the defendants' attempts to confuse the issues, stopped 
most of their attempts at harassment and overruled their efforts to 
get him to ignore your legislation. 

I understand there's a Dig push going on to reform our litigation 
system, including a new loser-pays rule, and no more joint and sev- 
eral liability. 

If either of these reforms had been the law 2 years ago, our case 
would never have been filed. The bond-holders would have been 
bankrupt along with Mr. Sutliffe. 

My lawyers told me when we filed the case they would probably 
have to take it all the way through trial. So I knew that we would 
be gambling my time for the next 2 years and a great deal of ex- 
pense money on what a jury would say about the accounting firms' 
conduct. 

Although I was comfortable in my belief that the bond-holders 
had been wronged by the accounting firms, I would not have filed 
this suit if, in addition to devoting my time to the case, I would 
have been required to pay their millions of dollars of attorneys' fees 
in the event that the jury, or a judge, did not agree with me. 

Likewise, without joint and several liability, instead of being 
made almost whole, the bond-holders in my case would have re- 
ceived virtually nothing. The issuer of the bonds, First Humanics 
Corporation, was described to us as a religious organization de- 
voted to caring for senior citizens, but was actually a shell corpora- 
tion that Sutliffe set up as a tax-exempt organization with Deloitte 
& Touche's assistance so that he could sell municipal bonds. It had 
no assets and was in bankruptcy. 

Swink & Company, the primary underwriter of the bonds, was 
bankrupt and Mr. Swink was being investigated for another securi- 
ties fraud. And I am told that he has been convicted. 

Although Mr. Sutliffe was living on a yacht in Florida, we knew 
that he had taken several trips to the Bahamas and we doubted 
that we would ever recover anything of any significance from him. 
Our only hope of recovery was from the accountants and the law- 
yers, without whose help Sutliffe could never have sold these 
bonds. 

I don't think that the accountants should be given any special 
treatment. Sutliffe could never have sold these junk municipal 
bonds without the instant credibility of having Deloitte & Touche 
and Price Waterhouse's names on the cover of his prospectuses. 
They knew about his problem past, and present, and were fully 
aware of their responsibilities under the securities laws. 

Nevertheless, they voluntarily took a gamble on Sutliffe and sold 
their name for a lot of money in order to give Sutliffe the credibil- 
ity he needed to sell his bonds. Nobody twisted their arms and 
forced them to do business with Mr. Sutliffe. 



75 

Like I said, I can bash lawyers with the best of them. But I think 
that much of the lawyer-bashing I hear is being pointed in the 
wrong direction. 

I can tell you from first-hand experience that the delays in our 
case were not caused by plaintiffs' lawyers, who only get paid after 
the case is over. The delays were caused by the defense lawyers 
who were paid by the hour to try to distract the judge from the 
merits of the case and to try to harass the plaintiffs into dropping 
their case. 

Please be careful not to pass legislation in the name of reform 
that really is designed to avoid responsibility for actual wrongs. 

One more thing. Please do not forget that securities fraud does 
not just hurt Wall Street speculators. Through my position on the 
bond-holders' committee, I saw many a tear on the face of retirees 
who lost their life savings on what they thought were safe invest- 
ments — municipal bonds. 

And please don't forget the senior citizens who were living in 
these nursing homes. Because Sutliffe and the accountants raked 
off so much money in up-front fees, not only were the nursing 
homes unable to pay the interest on the bonds, they were unable 
to take proper care of the senior citizens who were in their care. 

At trial, I saw and heard evidence that in some of the Illinois 
homes, there was so little money available for patient care, that pa- 
tients were not moved from their beds and had bed sores so exten- 
sive that the bed sheets had to be cut away. 

One man was found to have gangrene in his foot so severe that 
maggots could be seen in the wounds. One elderly man was per- 
mitted to wander off the premises and died of hypothermia. 

Please don't forget these innocent senior citizens, who through no 
fault of their own, are neglected and abused because some big ac- 
counting firm or Wall Street outfit was more interested in a quick 
buck. 

Senator Dodd. Thank you very much, Mr. Ramser. 

Mr. Radetich. 

STATEMENT OF EDWARD J. RADETICH, CPA, PRESIDENT, 
HEFFLER & COMPANY, PHILADELPHIA, PA 

Mr. Radetich. Thank you, Mr. Chairman. 

My name is Edward Radetich. I am a certified public accountant 
and a partner in the accounting firm of Heffler & Company, located 
at 1515 Market Street, Philadelphia, PA. 

Senator Domenici. Mr. Chairman, might I put you on hold for 
a moment? 

I'm going to temporarily leave. How long will you be here, Mr. 
Chairman? I'd like to come back. Will you be here 30 minutes? 

Senator Dodd. We're apt to be. 

Senator Domenici. I wonder if we might keep Dr. O'Brien 
around just because I'd like to ask him if he has any comparables 
to Mr. Radetich's testimony. 

Senator Dodd. I see him in the back of the room. 

Senator Domenici. Does his schedule permit that he stay? 

Dr. O'BRffiN. Yes, sir. 

Senator Domenici. Thank you, Mr. Chairman. 



76 

Senator Dodd. We'll do our best. I've got other meetings, too, but 
well try. Let's see if we can, OK? 

Go ahead, Mr. Radetich. 

Mr. Radetich. Since 1960, my firm, and since 1973, I personally 
have been involved in the administration of anti-trust and security 
class-action settlements. During this time, we have been engaged 
as class administrator in over 200 actions. 

As you are aware, the administrative process usually begins after 
the parties in a case have had a jury verdict or reached a settle- 
ment. The process includes notification to potential class members, 
evaluation of proof of claim forms submitted, distribution of recov- 
eries to approved claimants, and a final accounting to the court 
after all checks have been presented for payment. 

The notification process includes mailings to potential class 
members using names and addresses obtained from transfer 
records supplied by defendant companies, mailings to brokerage 
firms and large institutional traders that may have bought in 
street name, and various media publications, such as the national 
edition of the Wall Street Journal. 

Class members wishing to include themselves in the class and re- 
ceive a share of the settlement funds are typically given from 90 
to 120 days, depending on the matter, to file their proof of claim 
forms. 

As proof of claim forms are received, they are evaluated, market 
or allowed losses are calculated, deficiency and rejection letters are 
sent to those claimants who require them, and responses to these 
letters are processed. 

A report is then sent to the court enumerating our recommenda- 
tions as to which claimants are entitled to receive a share of the 
settlement funds. This evaluation and correspondence process usu- 
ally takes approximately six months from the filing deadline. How- 
ever, this parameter fluctuates, depending upon the number of 
proof of claim forms that are filed. After the court issues an order 
approving our recommendations, distribution is made to approved 
claimants. 

Senator, I come before you with some statistics. I have prepared 
and included an exhibit listing statistics for 69 recent securities 
cases in which we have been hired as class administrator. 

The exhibit contains the following headings — the name of the 
matter, the total dollar value of the settlement funds, the number 
of proof of claim forms that were filed, the market or allowed loss 
calculated for the approved claimants, the percentage recovered, 
which is a mathematical percentage showing the relationship of the 
market or allowed loss to the total dollar value of the settlement 
fund, the total dollars distributed to claimants, and the percentage 
recovery to claimants which is a mathematical percentage showing 
the relationship of the total dollars distributed to claimants to the 
total dollar value of the settlement fund. 

The market or allowed loss column requires some discussion. I 
am not a lawyer or damage expert and thus, do not have the exper- 
tise necessary to determine in any given case how much of the 
stockholders' market loss is legally recoverable damages under the 
securities fraud statute. However, from what I've been told, the le- 



77 

gaily recoverable damages are almost always much less than the 
investors' market losses. 

The most common method used today to calculate a claimant's 
recovery is to first calculate an out-of-pocket recognized loss for 
each claimant using the following formula: 

For those class members who buy and sell the security in question during the 
class period, the recognized loss is calculated as the difference between purchase 
price and sale price. For those class members who purchase the security during the 
class period and do not sell the security during the period, but rather, hold the secu- 
rity at the end of the class period, the loss is calculated by subtracting from the 
purchase price a per-share value which usually is the closing market value of the 
security on the last day of the class period. 

As you can see, this basically equates to a class member's market 
loss for the stock in question. The claimant will then receive a pro- 

f)ortionate share of the settlement fund based on this out-of-pocket 
oss. While this formula simplifies the calculation process, the for- 
mula clearly does not equate to actual damages that may have ex- 
isted due to the effects of the defendants' alleged misconduct. 

I am not able to tell the committee what percentage of a class 
member's damages are on average recovered in these cases. How- 
ever, I am able to tell the committee how much of the settlement 
fund is distributed to class members. 

An analysis of my exhibit shows that if you add the column enti- 
tled, Total Dollar Value of the Settlement Fund, add the column 
entitled, Dollar Distributed to Claimants, and mathematically com- 
pare the totals, 79.85 percent of the gross settlement funds for 
these matters have been distributed to class members. 

If you total the column entitled, Market or Allowed Loss, and 
total the column entitled, Total Dollar Value of the Settlement 
Fund, and mathematically compare these totals, you'll see that the 
average recovery is 13.5455 percent. Additionally, if you look at the 
median recovery on my schedule, you'll see that the median recov- 
ery is 22.8734 percent. 

Over the past 19 years, I have mailed checks, stock certificates, 
and discount coupons to hundreds of thousands of claimants who 
have filed proof of claim forms in class-action settlements that I 
have administered. In many matters, the checks represent a large 
percentage of a claimant's out-of-pocket or market loss. I have been 
contacted by many class members over the years regarding these 
cases and I can tell you that these citizens are most appreciative 
of a system that permits them to obtain these recoveries without 
any risk and little effort on their part. 

It is my opinion that without the current system, these individ- 
uals would have received nothing. Therefore, it is my belief that 
the current system does work. 

I'll be glad to answer any questions that you may have. Thank 
you. 

Senator Dodd. Mr. Radetich, you're going to submit that for the 
record? 

Mr. Radetich. It was part of my submission, and I also have ad- 
ditional copies if you'd like, Senator. 

Senator Dodd. Let me make use of my microphone here again, 
Mr. Billipp. That will be good. 

With all due respect, I presume, Dr. O'Brien, who is now in the 
back of the room, and you may have a different point of view on 



78 

some of these things. But if we start going back and forth, well 
never get these hearings over with. 

So you can look at each other's data. And we might ask you — 
in fact, I will ask you. Why don't you look at each other's data and 
I'd like you both to comment on each others data and submit that 
for the committee for this hearing today. That will satisfy the con- 
cerns of, I think, most Members. 

Let me start, Mr. Lerach, with you, if I can. Some of this stuff 
has been touched upon in all of your remarks, but I'd like to go 
back over it. 

This morning, of course, we heard some of the anecdotal testi- 
mony from some of these companies. 

One of the things that struck me is Mr. McCracken's testimony. 
He sat in the chair you're in, in fact, at this very moment. Accord- 
ing to his testimony, the plaintiffs only agreed to drop the case if 
the attorneys' fees were paid. And the plaintiff in that case, he said 
it was the 18-year-old daughter of the stock broker of one of the 
attorneys. 

That, to me, sounded pretty dreadful in terms of sitting up here 
and my reaction. But I'd like to give you a chance to respond to 
that particular fact situation. 

Mr. Lerach. I was not involved in that case personally at the 
time it was ultimately resolved, so I cannot tell you whether or not 
it is true the plaintiffs' lawyers refused to drop the case without 
being paid. 

What I do know is that although the judge sustained the com- 
plaint in that case as adequately pleading a fraud claim, he exer- 
cised his discretion under rule 23 to say tnat the individual plain- 
tiff who brought the case could not pursue it as a class action, and 
I understand directed the lawyer for that plaintiff and the lawyers 
for the company to meet and to settle the case. How it was settled, 
I do not know. 

Senator Dodd. Let me step back. Maybe this is the first question 
I should have asked you. We had different Senators here today. If 
I had to sort of try and paraphrase their feelings here, I think 
there's a sense that we don't want to in any way deprive legitimate 
plaintiffs at all from pursuing fraud. That would be a devastating 
action for this committee or this Congress to take. 

On the other hand, in fact, some of the witnesses here — Mr. 
Billipp, I think you expressed it very, very well — said there is the 
sense that possibly we need to have some additional steps or what- 
ever taken nere to try and at least minimize to the extent possible 
the frivolous lawsuit or the way of dealing with those matters. 

Mr. Lerach, maybe I'd ask you, as an attorney, you know this as 
well as anyone would know because you're so highly regarded in 
your profession. Is there any problem here with the issue of frivo- 
lous suits? Is it legitimate at all, or is it in your mind totally abso- 
lutely illegitimate/ 

Are there some recommendations you'd make if you were sitting 
up at this table and were looking at these issues that would strike 
you as being a reasonable approach to maybe try to minimize that? 

Mr. Lerach. I would certainly never say to you that there has 
not ever been a frivolous securities fraud suit filed. There have 
been and the rule 11 sanctions visited on the lawyers foolish 



79 

enough to do that, that are in the reported casebooks, show us that 
judges in fact know how to deal with that situation. 

I'm aware of one case and it wasn't me, where a $300,000 sanc- 
tion was visited upon a lawyer who got way too adventurous. The 
courts can deal with that kind of situation. Don't forget, securities 
fraud class-action suits are probably subject to more screens or fil- 
ters, I think someone called them earlier. 

First of all, the case has to survive a particularity of pleading re- 
quirement that's applicable only to fraud cases. It has to survive 
rule 11 like all cases. 

It then has to survive a rule 23 certification process by which the 
defendants, and you've heard these gentlemen testify what the de- 
fendants do to the class plaintiffs in this case. They get their tax 
returns, their investment histories. They make them sit for deposi- 
tions for 2 and 3 days at a time and probe every aspect of their 
life. So there's a lot of filters already there before one of these cases 
can become successful. 

Is there a problem? I honestly think there is a problem. I think 
the problem is that the securities laws aren't strong enough. I 
think the securities laws should be reformed to make perpetrators 
of fraud more accountable. 

How about treble damages from people who really commit delib- 
erate fraud? How about giving us an opportunity to go into State 
court and sue rather than always be forced to go into Federal 
court? How about enhanced sanctions on defense lawyers who con- 
ceal documents and on litigants who destroy evidence, and as soon 
as a class-action lawsuit is filed, eliminate all the electronic mail 
memory in public companies? 

There's a lot of abuses that could be looked at on that side of the 
street as well, Senator Dodd. 

Senator Dodd. And how about on your side? 

Mr. Lerach. I do not think that there are any existing abuses 
on our side of the street 

[Laughter.] 

Senator Dodd. No, no, no, no. 

Mr. Lerach. I do not believe that there are any abuses on our 
side of the street that cannot be adequately dealt with through rule 
11, sanctioning lawyers for filing meritless suits, through increased 
dismissals under rule 12, which the Wall Street Journal recently 
reported as occurring, and enforcement of the new and enhanced 
curtailed discovery rules which you're just voting on as Senators, 
the new amendments to the Rules of Civil Procedure, and the other 
discretionary tools that the judges already have. 

In fact, if I could just echo Ms. Reilly. You know what Ms. 
Reilly's complaint is? Her complaint is that not enough money is 
recovered in these cases. And if you want to respond to her com- 
plaint, what I would say is make the securities laws tougher so 
that more money can be recovered for the victims. 

Senator Dodd. I think if I heard here, she probably had that to 
say as well. And you made the point in your opening remarks 
about the difference between recovering the amount of her invest- 
ment as a percentage of the damages that have been done. But, as 
I heard her, there was a combination of complaints in all of that. 



80 

Explain to me again this notion — I heard what you just said in 
terms of the filters that defendants have to go through. But how 
does one explain that, even if it doesn't necessarily occur with any 
great frequency, why it seems to be occurring at least with some 
increased frequency within certain industries, such as these high- 
tech businesses? And again, maybe it's only a couple of rare cases 
and I'll give you an opportunity to respona to that, within days of 
the stock dipping, or in fact, in some cases, the stock even went up 
and there was indication that lawsuits were filed there without 
having been some sort of investigation. 

It would seem difficult for a proper investigation to be done to 
determine whether or not there was fraud — you may ultimately 
prove there was, but someone was talking about clairvoyancy — -just 
because the stock price dropped, the 10-percent rule. I think you 
addressed some of this in your opening remarks. 

Mr. Lerach. Let me try to respond to that. 

Occasionally, and not all that often, suits will be filed very quick- 
ly after a dramatic stock drop. And I'm not talking about 10 per- 
cent. I'm talking about the stock going down 15 or 20 points in a 
single day, when earnings are restated, a product is recalled, or 
some true calamity occurs. 

Now, remember. These stocks are widely owned throughout the 
United States. There are thousands of people buying these stocks 
on an ongoing basis. When you have that kind of cataclysmic col- 
lapse of a stock price, it shouldn't surprise us that more than one 
unhappy investor finds his way to lawyers to seek to sue. Now the 
question becomes, why does the suit get filed so quickly in that in- 
stance? 

Part of it is the lawyers are competitive. They have to be to sur- 
vive in our business. We are up against the best talent money can 
buy with unlimited funding day-in, day-out. It's almost Darwinian. 
We could not be here if we weren't competitive at the top. And yes, 
people do file quickly. However, remember the world is different 
today than it was 20 years ago. We do use word processing ma- 
chines, not quill pens. We have all the SEC filings of all public 
companies on a little disk this big. Anyone can get it. All of a com- 
pany's press releases are available. 

I can have, in an hour, a paralegal prepare a chart just like that 
for me to look at what has happened with a company. And what 
do you think I think when I see a pattern like this, where I see 
the top executive sold $3V2 million of stock for himself within 
weeks of when the stock collapsed? 

Yes, and we are experienced. We have brought many cases and 
we can prepare and file cases quickly. And I realize that 

Senator Dodd. What does that mean, someone else will file the 
lawsuit if you don't? 

Mr. Lerach. We are competitive. We want to control the case. 
We believe we can do the best job and we want to be first to file 
so that we can control the case, and the case will be competently 
prosecuted. 

The courts historically, and maybe this is a problem, the courts 
historically have rewarded the first filed case with control of the 
case as lead counsel. That's something the courts have done. We 
are reacting to that. 



81 

I think, in the end, Chairman Dodd, the inquiry really ought to 
be not how quickly was the case filed, but was the case meritori- 
ous. 

Senator Dodd. I agree. 

Mr. Lerach. And if it wasn't meritorious and it was filed too 
quickly, then let the judge visit sanctions. That fellow who got 
$500,000 for writing the fetter, I want to get that work the next 
time. But let him send a bill for the $500,000 to the lawyer who 
filed too quickly. 

Senator Dodd. And I think you'd appreciate this. Obviously, you 
look at a certain fact situation and you are experienced and others 
are, and you would look at this and say, well, there's something 
that may be going on here. Alternatively, there may not be. There 
may have merely been the mere coincidence of certain activities, 
nothing maybe as pronounced as that, the particular example that 
your chart shows. 

There is, however, I would argue, an immediate economic impact 
on that entity where the lawsuit has been filed. There's usually a 
good story, if it's a particularly well known company, certainly lo- 
cally, that the XYZ Corporation has just been sued for fraud, in 
terms of the financial standing of that company, its ability to raise 
capital, the value of its stock, whatever else it may be. In fact, one 
might argue that the filing of the lawsuit contributes in some way 
maybe to the collapse in the value. 

So I think, again, striking that balance here, that you've made 
a good point. Maybe we need to take a look and talk about how you 
determine the merit of a case, rather than who gets to the starting 
line first, if in fact that's a very revealing piece of information for 
this committee, because my suspicions are that it does contribute 
to some of the complaints about what happens to the value of these 
companies. 

Mr. Lerach. I don't think there's any question that it makes the 
executives furious when they're sued the day after a disclosure. I've 
heard it and I understand it. It's something that ought to be looked 
at. We talk about it ourselves on our side of the bar. 

But I still say at the end of the day, the inquiry ought to be, did 
the case have merit and if it didn't and it was frivolous, then that 
judge ought to sanction the lawyer who abused the system. 

Senator Dodd. Yes. Well, I appreciate that. And also, I raised 
this issue earlier with Mr. McLucas and others. One of the things 
we're trying to get is, of course, to get more voluntary disclosure, 
beyond what the letter of the law necessarily requires — for in- 
stance, who's being considered as a potential director? 

The law doesn't require you to talk about that. But I presume 
that that would be worthwhile information to have as an investor. 
Who's going to be on that board? I think it would be virtually im- 
possible to achieve the results by requiring it by law. 

So here we are trying, in a sense, to open that process up so that 
the average person may make some intelligent decisions, and 
you've heard me say this to the other panel. The concern I have, 
on the other hand, is that, in effect, we get a retrenching, pulling 
back in, in fact, going quite the opposite direction of coming for- 
ward, saying, boy, we're not going to tell them anything that we 



82 

don't have to, except what we're absolutely required to, thus con- 
tributing maybe in some ways to the very problems. 

Mr. Lerach. I hear that threat maae by public companies. I 
think if you and I were to look at the Dow Jones news wire on any 
given day, we'd rapidly conclude there is no shortage of self- 
aggrandizing corporate information being put out into the market- 
place. 

Senator Dodd. Let me ask you, Mr. Billipp and Mr. Ramser, and 
we appreciate you being here and it's not easy to step forward. In 
fact, I think some of you may feel, was I an idiot? I think you told 
us about your backgrounds, because obviously, you're not. You're 
experienced people and we appreciate, Mrs. Billipp, you're being 
here as well. But it's not necessarily comfortable to sit at a table 
in a public hearing and talk about 

Mr. Billipp. It's interesting, if nothing else. I've never been at 
a Senate hearing before. 

Senator Dodd. We appreciate it. We try to make it interesting 
for you. 

[Laughter.] 

But I asked Ms. Reilly the question and I'll ask it to both of you, 
because one of the concerns raised is investor confidence. As a re- 
sult of the experience you've been through, and there is different 
experience. 

Mr. Billipp. Yes, there were. 

Senator Dodd. Municipal bonds is a whole different set of re- 
quirements being debated and discussed up here as to how those 
ought to be handled. I, for one, have a problem with necessarily the 
registering of those things, but I think certainly the people who 
deal in them ought to be registered, and thats a different ap- 
proach. 

There are some concerns raised about the first aspect, but that's 
a side issue. 

But the question of whether or not either of you, in terms of your 
confidence as someone who would re-enter the market as a result 
of the experience you've been through. How would you comment on 
that? 

Mr. Billipp. I don't think it would affect my confidence because 
I already know that there is an avenue for remuneration, regard- 
less of the percentage. 

I think what I have learned through this whole process is that 
simply because something is stated in a prospectus that has been 
accepted or is acceptable to the SEC or any other regulatory body, 
that doesn't make it so. I think I would be a lot more careful per- 
haps. But it doesn't shake my satisfaction with the system that ex- 
ists in order to try and get remuneration for funds that have been 
lost through fraud. 

I think the legal system is OK I think that I perhaps would be 
scared next time that there might be something that again is not 
disclosed early. That was at least the problem in our case, a lot of 
failure to tell us about things that had happened in the past, any 
one of which, had we known, we would not have bought those 
bonds. 

Senator Dodd. You sound like you're really dealing with a real 
snakeoil salesman here. 



83 

Mr. Billipp. It was a mess, a terrible mess. 

Senator Dodd. Yes. So that's pretty clear. 

Mr. Billipp. And this is what I meant about the baby and the 
bath water. I want to make sure that any changes you make, don't 
discourage small investors like us from initiating these class-action 
suits. 

Senator Dodd. Again, other people have a different view up here. 
And for those in the room, as long as I am sitting in this chair of 
this subcommittee, the British rule ain't going to ever happen. I 
have other reasons, other things that I'd look at, but I think that 
approach worries me deeply. Again, maybe I'm a minority of one 
up here with that view, but I feel it pretty strongly. I think that's 
a very ill-advised way to proceed, in my view, on that particular 
point. 

Mr. Ramser. Frankly, I have a lot of confidence in the system. 
I've been involved in a multitude of investments, both prior to this 
episode and subsequent to that. Of course, maybe I look at it dif- 
ferently than other people, but I basically put everything on a risk 
pyramid. At the top of that is probably — well, I'd say the lottery, 
next, oil and gas ventures, and you get down to what was allegedly 
involved here, really safe investments. 

All this is an educational situation. But in due course, I think 
most of the time investors have been treated fairly, although they 
should be well aware of what they're getting into. 

Senator Dodd. So you still have a heightened 

Mr. Ramser. Very much so. 

Senator Dodd. Mr. Radetich, you talked about the 69 securities 
class-action settlements on which your firm has acted. And you 
said your analysis shows that 80 percent of the settlement proceeds 
go to investors. And the remaining part goes to the attorneys? 

Mr. Radetich. Attorneys' fees and costs and costs related to the 
notification and administrative processes. These costs can be quite 
high depending upon the matter. 

Senator Dodd. You've done these studies. You didn't figure out 
that aspect of this? 

Mr. Radetich. A lot of the time, we do not get a reconciliation 
of the fees and costs and therefore do not have that information 
broken down, Senator. 

Senator Dodd. On average. 

Mr. Radetich. We do not have a particular percentage that goes 
to administration and a particular percentage that goes to attor- 
neys' fees. I just don't have the figures in our data base to come 
up with that information right now. 

Senator Dodd. Well, you might try, just on the average. I realize 
that it varies, but I'd be interested in now that breaks out in those 
69 cases you were involved in. Is that available? Could you get that 
for me? 

Mr. Radetich. I could probably, yes. I may not be able to get it 
for all 69 matters, but I certainly can get it for a majority of those 
matters. 

Senator Dodd. Or even just to give me some averages, just to 
give me some sense of how that breaks out. 

Mr. Radetich. I can certainly do that. 



84 

Mr. Billipp. Chairman Dodd, may I volunteer a bit of informa- 
tion in our particular case? 

Senator Dodd. Yes. 

Mr. Bilupp. The suit was for the $16 million invested in this 
venture. We got back as bond-holders almost exactly 60 percent of 
the original investment. 

The law firm got about 9 percent of the out-of-court settlement. 
If one throws into the total receipt that we got back the value of 
the sale of the bricks and mortar, the total recovery in that case 
was about 60 percent, of which only 3 percent of the total went to 
the lawyers' fees who represented us. 

Senator Dodd. OK. 

Mr. Billipp. Maybe we just had an outstanding law firm. I think 
we did. But, in fact, this gentleman here is part of it, and I think 
they did an excellent job. 

Senator Dodd. I figured he was sitting there for a reason. 

Mr. Billd?p. But it's a very low percentage. 

Senator Dodd. I had a feeling you weren't going to castigate him 
when he took that chair there. 

Mr. Billdt»p. No, sir. 

[Laughter.] 

Senator Dodd. I want to get back, if I can. You do things other 
than just securities work. 

Mr. Radetich. We've done all types of class actions, that's cor- 
rect. 

Senator Dodd. Right. So tell me about nonsecurities work and 
how those numbers break out. 

Mr. Radetich. We have done administration of anti-trust mat- 
ters over the years. In an anti-trust matter, usually, the recovery 
is based on purchases during a particular class or time period. 
Quite frankly, in those matters, recoveries are probably less than 
in security class actions. 

I've always used as a rule of thumb in dealing with claimants 
who call on the telephone that in securities matters the median re- 
covery is approximately 25 percent of the out-of-pocket losses. I ex- 
plain to them that it is difficult to estimate an expected recovery 
prior to the proof of claim forms being filed and knowing how many 
people actually file and what the total recognized losses or out-of- 
pocket losses are for approved claimants. It is very difficult to come 
up with a percentage of recovery prior to the claim forms being 
mailed. 

We probably have more contact with class members than anyone 
in the process because, certainly, when class members start filing 
their proof of claim forms, they call our office and they visit our of- 
fice. They want to hand-deliver their proof of claim forms. They 
send us letters describing what had transpired. Many people tell 
stories of losing their life-savings. You get a litany of their entire 
life in addition to the proof of claim form. 

Probably one of the most common questions is what can you ex- 
pect in terms of a recovery? We usually indicate to these people 
that, in a securities class action, the rule of thumb is about 25 per- 
cent of the out-of-pocket loss. 



85 

In the anti-trust cases, that percentage is probably closer to 10 
percent. And of course, as I indicated, that is basically 10 percent 
of purchases during a particular class period. 

We have also done other class actions covering a broad variety 
of areas such as overcharges from governmental entities on real es- 
tate taxes. We did the Three Mile Island class action, in which peo- 
ple suffered damages as a result of the Three Mile Island accident. 

For those types of matters, there's a broad range of recoveries; 
anywhere from 1 or 2 percent of actual damages to some matters 
in which the recovery is 90 percent of the actual damages. 

But, as I indicated, the security matters probably have recoveries 
in the area of about 25 percent. 

Senator Dodd. And you further state that in securities matters, 
that the claimants do better generally than all other class actions 
that you handle. Generally. 

Mr. Radetich. Yes. 

Senator Dodd. Generally. 

Mr. Radetich. Yes, generally. 

Senator Dodd. OK Well, we're completing earlier than Pete Do- 
menici coming back and I'm sure there may be some additional 
questions. 

Would any of you care to comment at all on other things that 
you've heard? I've taken your time here. You've been very patient. 
I call the last panel always the patient panel because you had to 
sit and hear the other ones testify. Are there any additional com- 
ments that any of you would care to make? 

Mr. Lerach. Can I take a moment and just address one point? 

Senator Dodd. I had a feeling you might. 

[Laughter.] 

Mr. Lerach. Professor O'Brien frequently says that 96 or 95 or 
97 percent of these cases settle compared to 70 percent of litiga- 
tions generally and he draws an adverse inference from that. I'd 
like to make two points about it. 

From my reading of his study, his primary source of data is a 
securities class-action publication that focuses on settled cases. It's 
a publication that's meant to put out information to people about 
settlements. I think the fact that he looks to that publication pri- 
marily as a source of his data tends to skew his view as to how 
many cases are settled. 

It may be that 95 percent of all securities class actions that 
aren't dismissed under rule 12(b)(6), that aren't dismissed under 
rule 9(b), and that survive summary judgment settle, but that 
wouldn't surprise me and I don't think it would surprise anyone 
else. 

There is absolutely no data anywhere in the world to support the 
suggestion that only 70 percent of litigations generally settle. I do 
not know where that comes from. All studies or anecdotal tales 
that I'm aware of suggest that it's much higher. I just don't know 
where the 70 percent comes from and I don't think you should 
draw an inference which is being offered that every one of these 
cases settle for a lot of money. That's just not the truth. 

Senator Dodd. OK. Well, we'll ask that question regarding the 
70 percent. 

Did you want to comment? 



86 

Mr. Radetich. No. 

Senator Dodd. Well, thank you very, very much and I'm con- 
fident my other colleagues may have some additional questions for 
you, all of you here this afternoon. 

This has been a long time and I apologize. It's almost 6 hours, 
and the break because of the votes. We're going to reconvene this 
committee next Thursday for some additional testimony in this 
area. 

Let me just say to those of you here and those who may have 
left, this has been tremendously helpful to me, and I think to the 
Members here. I must tell you, for those of you who are not famil- 
iar with this process, the fact that this many Members were here 
ovor the past 6 hours to participate is not terribly common on a 
subject matter, particularly one that is rather esoteric in some 
areas because you're getting into law that most people are not fa- 
miliar with. But it indicates and it evidences an interest, I think, 
that is healthy. 

As I mentioned at the outset, there is no piece of legislation 
pending in the Senate. I realize there is in the House. My intention 
is to go through the process as the Chairman of this subcommittee. 
Obviously, I can't restrain anyone else from introducing a bill or 
not introducing a bill. But I thought it would be helpful to go 
through a process and listen and to try and discern what is out 
there, what is occurring, what ideas are there, is there a need for 
a fix, what sort of a fix, what would work, what wouldn't? 

I expressed my view on the British rule. I would say that on the 
issue of joint and several liability, I have a different point of view. 
I'm more inclined to look at that a bit for the reasons that have 
been articulated by others and I won't go into it, but I'm interested 
in hearing the views that people have on that particular aspect of 
this whole area. 

And obviously, again, it's critically important, I think, that every- 
one understand that it is not the intention of this subcommittee or 
this Member, nor anyone else I know of here, to in any way try to 
discourage the legitimate plaintiff from stepping forward and hav- 
ing his or her grievances redressed, be it through the actions taken 
by the SEC or, in 90 percent of the cases, through the private liti- 
gation process at all, but to try and make this work fairly and to 
see to it that while we're also encouraging confidence of investors, 
we're also very cognizant and feel it's extremely important that for 
companies out there trying to survive, trying to raise capital, trying 
to do a good job, that they should not be unfairly castigated in a 
process that would achieve those results wittingly or unwittingly. 

So it's a balancing that we're trying to engage in here and your 
testimony has been really helpful. I want you to know that, as it 
has been from the other panels. 

We look forward to the hearing next week and proceed from that 
point. But I thank all of you for being here. 

The subcommittee will stand adjourned. 

[Whereupon, at 3:30 p.m., the subcommittee was adjourned.] 

[Prepared statements, response to written questions, and addi- 
tional material supplied for the record follow:] 



87 

PREPARED STATEMENT OF SENATOR PETE V. DOMENICI 

Mr. Chairman, I sincerely want to thank you for holding these hearings. 

The integrity of our capital markets, the flow of accurate information and the abil- 
ity of entrepreneurs to innovate, grow and create jobs is very important for a vi- 
brant American economy. Preservation of those capital markets is an important re- 
sponsibility for this committee. The purpose of this hearing is to examine how 
10(bX5) litigation is affecting these markets. 

I am a lawyer. Three of my eight children are lawyers. All three of my sons-in- 
law are lawyers, and the woman my youngest son is "seriously dating" is a lawyer 
in the White House. Therefore, the issue of litigation is very personal to me. 

The number of lawyers has doubled since 1970 and the overall increase in litiga- 
tion is of great concern. It is competitiveness issue. Product liability, medical mal- 
practice, lender liability for superfund site clean up are all areas that impede our 
economic growth. 

But the area I find most troubling is the area of frivolous securities fraud. The 
allegation of fraud is a very ugly allegation. Our securities system is based on open 
disclosure of information. That system of disclosure is essential to the way our com- 
panies raise capital to innovate, grow and expand. 

Someone asked me the other day for a symbol of our America way. I decided that 
one such symbol might be our stock markets. 

Sometimes we take for granted these wonderful institutions that we call capital 
markets. They enable the United States to be a market driven, free market econ- 
omy. 

In fact, I am amazed by the requests for technical assistance from foreign visitors 
to the U.S. who are interested in establishing their own capital markets, and stock 
exchanges. They see capital markets as a prerequisite step to their emergence as 
free market Democracies. 

The disclosure of accurate information under our securities laws makes our sys- 
tem work. It provides the confidence that encourages individual and institutional in- 
vestors to take a risk by investing their money. 

And Rule 10(bX5) is a cornerstone of our securities laws. Because of its promi- 
nence and its power as a tool, we have to approach changes very prudently. 

I support a vigorous 10(b)(5) private right of action so that shareholders — who are 
defrauded can be made as whole as possible. Perpetrators of fraud who compromise 
our capital markets for their own personal gain should pay a stiff penalty. 

But there is a disturbing trend. During the last five years one in eight companies 
traded on the New York Stock Exchange were sued for 10(b) violations. 

The truth is, Mr. Chairman, there isn't that much fraud, but there is that much 
litigation. 

But most companies who raise money in our capital markets and whose stock 
trades on our stock exchanges should not be deemed defrauders just because the 
stock drops. 

Former SEC Chairman Richard Breeden has noted that the "problem of meritless 
securities litigation . . . is a serious one" and that "such litigation imposes costs on 
the defendant, which . . . are ultimately borne by the issuer's shareholders." He 
concluded, that legislative reforms to deter meritless claims "would be highly bene- 
ficial." He also commented that the current system fails to distinguish strong claims 
from weak or meritless claims." 

The Supreme Court in 1975, recognized that "litigation under Rule 10(bX5) pre- 
sents a danger of vexatiousness different in degree and kind from that which accom- 
panies litigation in general." (Blue Chip Stamps v. Manor Drug Store) 421 U.S. 723 
739 (1975). Unfortunately, the Supreme Court prophesied too well the potential for 
abuse. 

This leads me to my fundamental premise about this issue: legal rights also carry 
responsibilities. And for this reason I am also strongly against 10(b)(5) being used 
to abuse our civil justice system. It should not be used to stifle entrepreneurs and 
to chill the flow of information from the companies to the analysts and investors. 

There should be no right of action just because a stock price drops. That isn't 
fraud. A certain degree of stock volatility is the nature of the capital markets. 
Stocks go up and down. That is the American way. 

While I am critical of the system allowing too many frivolous securities fraud 
cases I am also doubly critical of the system because I am not sure that the bad 
guys are being penalized enough. Our system should penalize them both civilly and 
criminally. 

I am not sure that victims are being appropriately compensated. 

This hearing has a narrow, but important focus, as far as I am concerned. That 
focus is to explore why we are seeing 10(bX5) lawsuits filed within weeks, some- 



88 

times days or even within hours after a stock drops in price. The companies are 
being hurt. Joint and several liability threatens accountants, outside directors and 
other professionals even if they are only incidentally responsible for an investor los- 
ing money. We are seeing less disclosure of information and we are seeing fewer 
and fewer experienced, and successful people willing to serve as outside directors. 

Since our first panel is a panel of CEOs from some of the country's high tech com- 
panies, let me talk about their part of the this problem first. I am delighted that 
each of you have agreed to testify. I know it is not an easy thing to come forward. 

Tom Dunlap, the General Counsel for Intel, is a major employer in New Mexico 
and is planning a $1 billion expansion in Rio Rancho, New Mexico. It is a company 
I am proud is partially located in New Mexico, and as national leaders we should 
all be proud that Intel is a significant participant in our national economy. Intel has 
been involved in seven of these lawsuits triggered when the stock dropped in price. 

I don't want to steal Tom's thunder, but I am pleased justice was done when the 
first set of these cases were withdrawn. That was the good news. The bad news is 
that it took more than six months and the expenditure of substantial Intel resources 
and legal fees to convince the plaintiffs that they had no case. 

You won't believe circumstances giving rise to the second round of cases was, ex- 
cept to say that the case was filed when Intel failed to correctly read the mind of 
another judge. I will let him tell you about it. 

According to Scott McNealy, the President of Sun Microsystems and his company 
has been sued several time — once when the stock went down, once when it went 
up and once for settling one of the previous suits — a derivative suit. The basis of 
this law suit was that the company settled when it shouldn't have settled. 

I think common sense leads you to the conclusion that there is a problem. 

I am a student of the economy. There are certain segments that are critical tech- 
nologies for our long term economic growth. These include computers, other elec- 
tronics and biotechnology firms. These are the firms that are getting sued. I am de- 
lighted that we have four representatives from these critical technology areas. If our 
economy were growing as a whole as robustly as these companies, many of our fiscal 
problems would be much easier to solve. 

John Adler is the CEO for ADAPTEC and is here representing the American 
Business Conference which is an organization of the 100 fastest growing companies 
in America. If there are companies that represent America's future, it is the ABC. 

We also have Edward McCracken the President and CEO of Silicon Graphics ap- 
pearing as a witness. In addition to his very important testimony, he can also tell 
us about his company's involvement in the production of "Jurassic Park." How did 
you make those dinosaurs look so lifelike? I have a grandchild who wants her very 
own. 

I hope we can spend most of the day talking about these types of law suits. 

New Mexico is the home to Los Alamos and Sandia National Laboratories. It is 
the home of some of the finest scientists, and some world-class innovation. I have 
seen some of these scientists leave the laboratories and start up high technology 
companies. They tell me that the science and the innovation is the easy part of a 
new business. The really difficult challenge in the financing. 

The New Mexico banks take them as far as they can. I know a banker in Los 
Alamos that I refer to as the banker to some of the most important technology in 
the world. That is Bill Enloe. But frankly, the successful companies soon outgrow 
the banks and end up looking for venture capital and eventually move on to raising 
capital on Wall Street. 

I spent the last recess touring New Mexico meeting with entrepreneurs. We fo- 
cused: on economic development. We focused on start-up companies and creating new 
jobs so that our kids don't have to leave the State to find a job. 

Banks are not lending as much as they used to. Venture capitalists have cut back 
their support for start-ups. This is one reason why we are seeing more initial public 
offerings. 

I know first hand how hard these entrepreneurs struggle to make it. Some don t. 
They seem to reach a bit of success, get listed on a NASDAQ, or one of the bigger 
exchanges and the next thing they know, they are getting sued because their stock 
prices have dropped. 

What is happening in New Mexico is very minor compared to the activity in Sili- 
con Valley in California, or Route 1 in Massachusetts or at the research triangle 
in North Carolina. These high tech enclaves are the source of a great deal of eco- 
nomic growth and they are Deing sued at an alarming rate. They are being sued 
mostly because their stock dropped by an amount that triggers a litigation for- 
mula — a point at which it becomes worthwhile for the law firms to bring cases. 

My problem and my question is why are these cases being filed so quickly? How 
can anyone know whether anything improper has been done much less whether 



89 

fraud has been committed. Review with me for a moment the elements for a fraud 

case: 

— Material misstatement or omission of a material fact; 

— Justifiable reliance by the person harmed; 

— Knowledge that the person harmed would detrimentally rely upon the statement; 

— Intent to commit fraud or scienter on the part of the perpetrator. 

Those are a lot of facts to verify before a lawsuit should be filed. I am delighted 
that we have some members of the bar here today to explain how these elements 
can be diligently explored in such a short time before the law suit is filed. 

There are a lot of interests to carefully weigh. There are the shareholder/investors 
whose rights must be protected and whose investment must be subject to the light 
of full disclosure. There are the CEOs trying to run companies and contribute the 
economic strength to this great Nation. There are the outside directors who bring 
an independent viewpoint and the voice of experience to start-up and developing 
companies who must not be discouraged from serving, but who must conscientiously 
perform their duties. There are the auditors and CPAs who must carefully certify 
the financial statements upon which many investment decisions are made. 

These lawsuits are making it harder for American companies to raise capital, and 
to attract experienced board members. At the same time these lawsuits distract en- 
trepreneurs and make it more difficult for them to focus on the business of being 
competitive. 

I have talked to shareholders and they don't seem too keen on the system either. 
Cases settle 96 percent of the time. Plaintiffs' lawyers typically receive about 30 to 
40 percent of the settlement before the plaintiffs receive anything. Institutional in- 
vestors receive the lion's share of what is left and the individual investor recovers 
maybe 5 cents of every dollar of his or her losses. 

This doesn't seem to be a very satisfying result. The system has innocent people 
settling the cases because no other course of action makes economic sense. It costs 
more to prove innocence than it does to settle. True fraud perpetrators are paying 
no more than the unfortunate and blameless. Shareholders recovering pennies re- 
gardless of whether there was fraud or not. 

Some argue that the frivolous lawsuit is not very serious and they point to the 
increase in initial public offerings. But this committee knows very well that banks 
are not lending to Dusinesses. We had a hearing on venture capital and witnesses 
testified that venture capital funds have reduced their investments in small busi- 
ness. One study showed that new investment by venture capital firms in small busi- 
ness shrunk by fifty percent from 1987 to 1991. 

This means that firms are being pushed into the equity markets. This probably 
explains why there has been an increase in initial public offerings notwithstanding 
the threat of litigation. 

Years ago I came before this Committee very concerned about junk bonds, and 
the impact of hostile take overs on our economy and the safety and soundness of 
our financial institutions. Only years, later was it proved that I was right about the 
problem. 

I have the same feeling about this phenomenon. My concern isn't just a gut reac- 
tion. It is substantiated by academic studies by Janet Cooper Alexander and Joseph 
Grundfest at Stanford, Robert Samuelson, and one of our witnesses today, Vince 
O'Brian. 

I want to hear what our witnesses have to say. 



PREPARED STATEMENT OF SENATOR JOHN F. KERRY 

Mr. Chairman: I congratulate you for holding this timely hearing on securities 
litigation reform and on the "Financial Fraud Detection and Disclosure Act," S.630, 
which I have introduced in the Senate, which would amend Federal securities laws 
to facilitate the reporting of indicators of financial fraud to regulators by account- 
ants. 

As I learned in painful detail over the past four years over the course of inves- 
tigating the Bank of Credit and Commerce, International (BCCI), current account- 
ing practices too often fail to detect financial fraud, here in the United States as 
well as abroad. 

This creates serious consequences for the securities industry and capital markets. 
External auditors play a critical role in the self-regulatory process in the financial 
marketplace. When an external auditor certifies the financial statement of a busi- 
ness, it is simultaneously providing different services to different audiences. 



90 

For the shareholders of the institution it is certifying, it is providing what is sup- 
posed to be a clear, full, and fair description of the actual performance of the busi- 
ness to assist the shareholder in determining the value of his investment, the per- 
formance of the company, and the strength of the company's management, as well 
as assurances that the company has no untoward risks from violations of law or reg- 
ulatory compliance. 

To anyone else, an annual certification represents what may be the principal 
means by which an outsider can evaluate the safety of entering into a transaction 
with a business. As Securities and Exchange Commissioner Richard C. Breedon tes- 
tified earlier this year: 

Both large institutions and the smallest individual investor, together with sup- 
pliers of goods and lenders, rely on financial statements in deciding whether or 
not to invest in a firm or to extend credit, and if so, on what terms. The more 
accurate those financial statements are in portraying the financial condition and 
operating results of firms, the more efficient the overall market can be in allocat- 
ing capital and producing the most efficient economy. However, to the degree that 
financial statements do not fairly or accurately portray a firm's financial condi- 
tion, credit and investment decisions will be made that may not have been made 
on the same terms had the firm's true financial condition been accurately under- 
stood. 

It is by no means easy for any outsider, including accounting firms, to detect the 
self-dealing, off-the-books accounting, the use of nominees and front companies, 
schemes to inflate income, manipulation of inventories, dummy post office boxes and 
phony "brass plate" corporations, and similar practices of the crooks, criminals, and 
con-men who spring up anywhere they find an opportunity. 

When the Federal securities laws were enacted 60 years ago, Congress considered 
establishing a corps of government auditors to verify corporate balances of public 
companies and review their books. Congress then abandoned this notion in favor of 
giving the private accounting profession the responsibility for auditing the financial 
statements of publicly traded companies. 

Today, neither the SEC nor any other Government agency is in a position to re- 
view public filings by corporations in any detail. That responsibility has been ceded 
to private accountants. Recognizing the difficulties inherent in catching fraud, no 
one is in a better position to police it at the first instance than the accountants re- 
tained to certify that a company's books and records present a true and accurate 
picture of its financial condition. 

The Financial Fraud Detection and Disclosure Act would give the SEC the ability 
to issue new requirements to auditors to supplement current auditing standards, to 
assist them in detecting financial chicanery. 

It also strikes a balance between the auditors responsibility to the firm that has 
engaged the auditor, and the auditors' responsibility to the public, through estab- 
lishing a system for the reporting of information concerning illegal activity that al- 
lows management to take corrective action, and only brings the Government into 
the situation when it becomes clear that remedial action will not or cannot be taken. 
The Act would impose a clearly defined set of responses governing accountants 
when they detect information that an illegal act may have occurred. 

Under the Act, auditors are to first assess the information, consider the impact 
of it on the financial statement, and then to inform management and the company's 
audit committee or board of directors. If the auditors believe the illegal act may 
have a material effect on the financial statement of the issue, and that management 
has not taken timely and appropriate remedial action, the auditors are required to 
issue a formal report to the firm's board of directors. The board is in turn required 
to notify the SEC of the report, with a ccpy to the auditors. If the board fails to 
take this action, the auditors are required to provide a copy of the report to the SEC 
themselves, and have the option of additionally resigning from the auditing engage- 
ment. 

An important constraint on auditors — the fear that they might be sued for telling 
the Government of the illegality they have discovered — is eliminated by the Finan- 
cial Fraud Detection and Disclosure Act. The Act protects auditors from liability in 
any civil litigation for "any finding, conclusion, or statement expressed" in a report 
to the Board or the SEC under the Act. 

And the Act contains reasonable provisions for civil penalties for accountants who 
willfully violate the procedures set forth to respond to information concerning finan- 
cial fraud, enforced by the SEC. 

The gap between the public's expectations of accountants and the protection actu- 
ally offered to the public by certified audits is far too large. This legislation is de- 
signed to narrow that gap, and if enacted, provide strong incentives for accountants 



91 

to take strong action whenever they discover financial wrongdoing. If it proves in- 
sufficient to protect against every substantial securities fraud, it may still do much 
to limit the scope and scale of the damage that results when such frauds persist 
over many years, and long after the first signs of wrongdoing have been apparent. 

S. 630 has been endorsed by the American Institute of Public Accountants, by the 
Financial Executives Institute, and by outgoing SEC Chairman Breedon. H.R. 574, 
introduced by Congressman Wyden, has already moved through Committee in the 
House. 

Mr. Chairman, with your assistance, I would hope we could mark-up S.630 in the 
Senate Banking Committee prior to the close of this legislative session. I look for- 
ward to working closely with the Chairman and the Members of this Committee in 
an effort to achieve passage of this Act this year. 



STATEMENT OF EDWARD R. McCRACKEN 

President and Chief Executive Officer, Silicon Graphics, Inc. 

and co-chairman, american entrepreneurs for economic growth 

June 17, 1993 

Good Morning. 

Mr. Chairman, I am Ed McCracken, President and Chief Executive Officer of Sili- 
con Graphics, Inc. I'm pleased to be here today to present my views on the effect 
that private securities lawsuits have on small, innovative companies. I've been 
asked to speak to this subcommittee today on behalf of the American Electronics 
Association and the American Entrepreneurs for Economic Growth, as well as Sili- 
con Graphics. But first, I would like to spend a few minutes talking about our com- 
pany to provide you with an understanding of my perspective. 

Silicon Graphics is a true American success story. The company was founded in 
1982 by Dr. James Clark, a Stanford University computer science professor and six 
of his graduate students who had the vision that there was a market for computer 
systems based on three-dimensional graphics. When Dr. Clark's research was ready 
to be put in practice, he paid visits to established computer companies to try to sell 
his idea to them. Not a single company understood the impact. As a result, Dr. 
Clark founded his own company, and today many consider Silicon Graphics to be 
the undisputed leader in visual computing. 

Already there are hundreds of uses for visual computing. Ford uses our computers 
to design cars. Scientists at Chiron Corporation are using Silicon Graphics computer 
systems to model molecules in hopes of finding cures for diseases such as AIDS. 
Computer graphics artists at Industrial Light & Magic used our computers to create 
the spectacularly realistic effects in the movie "Jurassic Park." 

More recently, we were selected by Time Warner Cable to develop technology for 
a full-service interactive digital cable television network to be tested in Orlando, 
Florida. The new television system will vastly expand information and entertain- 
ment choices for people, providing them with a host of new innovative services such 
as video-on-demand, educational resources and interactive video games and business 
services. 

In February of this year, President Clinton and Vice President Gore visited our 
headquarters to unveil the Administration's high -technology initiative. Several Sili- 
con Valley companies were considered for the visit; I believe our company was cho- 
sen in part because it serves as an example of growth .and innovation. 

With sales of $1 billion, we employ over 3,500 people in 80 locations worldwide. 
Our corporate headquarters are in Mountain View, California and we operate an 
international headquarters in Switzerland. We are also a large exporter, with ap- 
proximately 50 percent of our sales outside North America. For the past two years, 
Silicon Graphics was recognized as one of Fortune magazine's 100 fastest growing 
companies. 

The people at our company are motivated by pursuing interesting and challenging 
ideas. They understand that today's pace of technological advancement can be har- 
nessed to achieve a ten-fold improvement in a computer's performance every three- 
and-a-half years, and they are excited about the resulting transformation of our in- 
dustry. They adapt readily to change, and have learned how to incorporate it in 
their daily lives. 

I could talk at length about the scientific, engineering and creative successes that 
our technical teams nave achieved, our efforts to become a standard for the conduct 
of business worldwide and our success at expanding employment at home. This 



76-7fi1 - cm 



92 

morning, however, I want to discuss an inhibitor to U.S. competitiveness — securities 
class-action lawsuits. 

Let me begin with a premise: that the only way that new ideas in the scientific 
and business community succeed is through innovation. Throughout the country, 
companies are founded each week because an established enterprise wouldn't em- 
brace a new idea or wasn't willing to take a risk on a new way of doing business. 
In the computer industry, the stories are legendary — take for example Apple Com- 
puter, founded because an engineer at Hewlett-Packard couldn't sell his idea of a 
personal computer to management. 

Yet even when companies like Silicon Graphics are successful there is the con- 
stant threat of a securities class-action lawsuit. Because stock price volatility goes 
hand-in-hand with risk taking, innovative companies become targets of these abu- 
sive suits. These lawsuits, usually filed under Rule 10(bX5) under the Securities Ex- 
change Act of 1934, often allege that companies knew or should have known about 
problems earlier than disclosed, and that investors paid an artificially high price for 
their stock. 

When the courts first authorized the use of the class-action technique in connec- 
tion with 10(bX5) law suits, it no doubt was done to ferret out real fraud and wrong- 
doing. However, I believe that the current practice of filing off-the-shelf legal com- 
plaints when a company announces a downturn in performance amounts to an un- 
controlled "tax on innovation." Under today's system, companies can be exposed to 
potential litigation whenever their stock price falls by more than a few percent, even 
if there was absolutely no violation of securities laws or fiduciary responsibility. Let 
me tell you about our experience with this kind of lawsuit. 1 

On April 3, 1991, we announced that our revenues for the quarter ended March 
30, 1991, would be lower than the previous quarter. This was the company's first 
revenue decline after six consecutive quarters of growth. The principal cause of the 
decline was disruption of customers' purchasing decisions because of the Persian 
Gulf War. As a result, the huge volume of orders that usually come in during the 
last two weeks of a quarter failed to materialize. After the announcement, the com- 
pany's stock price fell about 10 percent, from $42.50 to $38.00. Several weeks later, 
the company was sued for securities fraud. I was personally named as a defendant 
in the suit, along with the Chairman of the Board and founder of the company, Jim 
Clark. The complaint alleged that we knew in February 1991 that our results for 
the March quarter would he below Wall Street expectations and that we failed to 
disclose this information. 



1 The litigation about which I am testifying is Amy Zaltzman v. James H. Clark, Edward R. 
McCracken and Silicon Graphics, Inc., which was filed on May 23, 1991 in the United States 
District Court for the Northern District of California. The lawsuit was dismissed with prejudice 
on June 2, 1993. 

In addition to the Zaltzman litigation, SGI has been involved in three other cases involving 
some of the same plaintiffs' firms that are active in filing securities class-action lawsuits. The 
timing of the filing of these suits is revealing. On March 11, 1992, the Company entered into 
an agreement to acquire MIPS Computer Systems, Inc. (the "Merger Agreement"). Almost imme- 
diately after the announcement of the MIPS transaction, three lawsuits were filed: 

On March 13, 1992, a putative class-action lawsuit entitled Myron Harris v. MIPS Computer 
Systems, Inc. et al was filed in the Superior Court of the State of California for the County 
of Santa Clara. The plaintiff, purportedly suing on behalf of all MIPS stockholders, alleged that 
its directors, and Silicon Graphics as co-conspirator, breached their fiduciary duties to MIPS 
stockholders and committed fraud by failing to realize a higher premium for MIPS stock, by un- 
lawfully profiting at the expense of MIPS stockholders, and by failing to disclose material facts 
concerning the Merger. The plaintiff sought damages, an injunction or set-aside order, and the 
appointment of a receiver to auction MIPS. 

Also on March 13, 1992, a putative class-action lawsuit entitled Max Fecht v. MIPS Commuter 
Systems, Inc. et al. was filed in the Court of Chancery of the State of Delaware for New Castle 
County. The plaintiff, purporting to sue on behalf of all MIPS stockholders, alleged that MIPS 
and its directors breached their fiduciary duties by negotiating the Merger Agreement in haste 
and failing to protect MIPS' common stock prior to consummation of the merger. Silicon Graph- 
ics was also named in the lawsuit as a co-conspirator defendant. The plaintiff sought to enjoin 
or set aside the Merger, and also claimed an entitlement to compensatory damages. 

The Harris and the Fecht cases both were withdrawn, but only after many months of proce- 
dural wrangling and expense. 

On March 17, 1992, a putative class-action lawsuit entitled Diane Provenz and Ahikim 
Euenberg v. Robert C. Miller, et al. was filed in the United States District Court for the North- 
ern District of California. The plaintiffs purport to represent a class of all persons who pur- 
chased MIPS' common stock between January 31, 1991 and October 9, 1991. Named as defend- 
ants are MIPS and certain executive officers of MIPS. Silicon Graphics is not a named defend- 
ant, but is forced to defend this suit as successor to MIPS. The complaint alleges that defend- 
ants violated various Federal securities laws and California statutes by making material mis- 
representations and omissions during the Glass Period. This case is still pending. 



93 

To put this in perspective, for small companies like ours, quarterly financial re- 
sults are like elections to the Senate. And like elections, despite the best polling, 
the results sometimes surprise us. Silicon Graphics has always been extremely cau- 
tious, some might say conservative, in its public disclosures. And we have never said 
that our expectations are a certainty. 

During that quarter, we had said to our stockholders, the SEC, and to Wall 
Street, *TlememDer — our country is in a War, we're in a recession worldwide, and 
we're depending for some of our revenues on a computer system innovation that we 
never before manufactured, and for which we need new parts." We also said that 
a majority of our orders come during the last month of the quarter; we wouldn't be 
in a position to know the results until then. We knew there were many risks, and 
we said so. 

Once we knew the quarterly results, we disclosed them two weeks earlier than the 
normal time for the company^ release of quarterly results, in orders to inform the 
market immediately of the unexpected downturn. Despite our caution, we were 
sued. 

What did we do? First, our attorney called the plaintiffs lawyers, saying, look, 
this makes no sense. The company may have missed its target, but there wasn't any 
fraud. Generally, if someone has a complaint against me or my company, I call the 
person, to understand the situation and to try to resolve it. As you know, in these 
suits, there's often no actual "person" to call. Just a name who may be one of a num- 
ber of plaintiffs regularly used by these law firms. 

Our initial attempt went nowhere. So we brought in our outside attorneys and 
conducted an investigation, to make sure we understood the situation completely. 
Then we said to the plaintiffs attorneys, "Look, before this goes on forever, we'll 
give you our documents"; then we invited them in — this is before any formal "discov- 
ery" — and having given them our records, suggested that they interview our Vice 
Chairman, no holds barred. 

So they conducted a day-long interrogation, about everything from accounting 
records to internal forecasts to which orders were coming in for which of our product 
lines during the Gulf War and the months immediately thereafter. Although uncon- 
ventional, we felt that this would convince the plaintiffs lawyers that their allega- 
tions were completely unsubstantiated. One of the plaintiff firms did drop out, but 
others kept this case going. 

We then filed a motion to discuss the case, which was granted by the court. A 
copy of Judge Williams' order is attached for your information. As is typical, how- 
ever, the plaintiff was given the opportunity to refile her case. Then having exam- 
ined her new pleading, we had to file a second motion to dismiss, and also challenge 
the standing of the named plaintiff— the 18 year old daughter of the attorneys' 
stockbroker — as an adequate class representative. At the next hearing, the court 
strongly urged that the case be dropped. However, the plaintiffs attorneys refused 
to drop the case without a payment. 

After much internal debate, we made the decision to pay a settlement 2 and get 
back to business. It was less expensive to do that than to go through the next proce- 
dural steps — discovery and summary judgment — and win. So this completely 
meritless case finally was dismissed this month, after two years and well over $1/ 
2 million to defend. 

But the real cost to the company was much more than that. As a result of this 
suit: 

• The core management team was distracted from our business for days at a time, 
stretching over this two year period. This wasn't limited to just Jim Clark and 
me — who were personally accused of fraud — but many key players in the company 
from R&D, finance, planning, marketing, sales and manufacturing. 

• We curtailed our R&D spending. Our engineers always have more ideas then we 
have resources to pursue. We simply had to tell our scientists to reduce their re- 
search list, because the money was going to legal fees. 

• Finally, our integrity as a company was "put into play." This suit accused Silicon 
Graphics, Jim Clark and me of fraud, knowing deception, and reckless disregard 
for the truth. No one who knows anything about me or my management team 
would believe that fraud, deception or untruthfulness would be tolerated for a 
minute at Silicon Graphics. 



2 We don't know if the plaintiff recovered anything. But we do know that her stockbroker fa- 
ther had purchased Silicon Graphics options, as well as stock, in her name, and that she made 
money on her entire "straddle" strategy. 



94 

I believe that the very threat of these lawsuits — in which it is business as usual 
to accuse someone of fraud — carries a further, ongoing cost. And that is why I call 
it a tax on innovation. The charts which I am showing you illustrate this. 

Chart 1 shows our revenue growth over the last 6Vz years. 

Chart 2 demonstrates how our employment has grown over that period. 

Chart 3 highlights the pattern of our stock price since the company went public 
in 1986. 

As Chief Executive Officer, I am responsible for the items shown on Charts 1 and 
2. If we can grow revenues and increase employment, I think we're doing the right 
thing. And, knowing that the stock market is erratic, and is influenced by so many 
things outside our control — economic conditions, other people's expectations, port- 
folio investing decisions — we would like to spend much less time on the pattern 
shown on Chart 3. 

However, because of the very volatility of the stock price for innovative companies, 
they become targets for these types of suits. Hundreds of these suits are filed each 
year. Just among computer systems companies the following have been targets: 
Apple, Compaq, Control Data, Data General, Digital Equipment, Hewlett-Packard, 
IBM, Sun Microsystems, Tandem and Unisys. I find it hard to believe that all of 
these companies are headed by management teams who commit fraud or who have 
a "reckless disregard for the truth.'' 3 

We need to eliminate the incentives from the current system to file frivolous 
cases. Once a frivolous suit is put in motion, it is impossible to terminate the suit 
without some cost to the innocent company. In Silicon Graphics' lawsuit, the judicial 
system worked to weed out this meritless case — but only after two years of effort 
and after substantial legal fees were incurred. If the system were operating effec- 
tively, this case should never have been brought. 

But from the point of view of the plaintiffs law firm, why shouldn't the case be 
filed? You don't have a "real" client, who controls the case and will temper the attor- 
neys' zeal with the realities of relationships or economics. The plaintiff isn't worried 
about legal expenses, since he or she never pays any legal fees. And the plaintiffs' 
attorneys aren t worried about expenses, since they get paid by the defendants in 
the settlement arrangements. Even in a case such as ours, in which we had many 
advantages — a short class" period (one quarter vs. many months or years in other 
cases), an experienced judge who had heard many class-action cases over the last 
decade, and rulings consistently against the plaintiff — the plaintiffs attorneys were 
able to force a settlement from which they recover their fees. Simply put, accusing 
companies and individuals of fraud has virtually no downside, and provides a lucra- 
tive career for those attorneys whose pursue it. 

From a policy perspective, why are those suits such a problem? Because, as I said 
earlier, they reward the cautious, and penalize the innovative. Smaller companies, 
like Silicon Graphics are engines of growth precisely because we innovate — and that 
innovation carries risks. We may run with an idea that other companies have re- 
jected, or take a chance on a concept that larger companies refuse to entertain. 
Some of what we do is counter-intuitive. For example, years ago we embraced the 
new open architecture MIPS RISC microprocessor, because our innovations in pow- 
erful visual computers could not be realized if we used what was more conven- 
tional — and safe. We had to take a chance — and then work like the dickens to make 
sure we succeeded. Innovation is why companies like ours in Silicon Valley succeed, 
and also why some fail. 

I believe that the high-technology industry, and in particular, small- and medium- 
sized companies, offer tremendous potential for fueling our Nation's economic resur- 
gence. A recent analysis of 2,851 high-technology emerging companies found that, 
on average, these companies intend to increase their workforce by 5.2 percent in 
1993. I am currently the co-chairman of the American Entrepreneurs for Economic 
Growth, an organization that represents 6,600 emerging growth companies and 
760,000 American jobs. A recent study surveyed 428 venture-backed companies and 
found that between 1985 and 1991, these companies generated 92,500 highly skilled 
jobs in the United States. During the past five years, these companies posted 18 
percent job growth per year. The National Science Foundation found that entre- 
preneurial companies produce twice as many innovations per R&D dollar. Ironically, 
the very companies creating the jobs and producing the innovations in this country 
are the prime targets of these abusive securities suits. 



3 A recent study by National Economic Research Associates, Inc., reached the same conclusion. 
It explained the "disproportionately large number" of securities class-action suits against high- 
technology firm's as a product of volatile stock prices, observing that "[t]here is no reason to 
believe that this industry is more prone to fraud than others." 



95 

If high-growth companies are to be competitive in the global marketplace, their 
management teams must be encouraged to focus on the important things — revenue 
growth, job creation, and innovation. We understand — and accept — that because we 
do things in a new way, investors' perception of our worth may change rapidly, and 
that our stock prices may be quite volatile. 

What is counterproductive is a system which allows a few attorneys to so easily 
translate this volatility into accusations of fraud, forcing companies to spend hun- 
dreds of thousands of dollars — if not millions — to investigate, defend and settle, and 
to divert their attention from the critical issues of growth and innovation. And these 
suits can be brought with no "real" clients, and at virtually no risk to those pursu- 
ing them. I know that the overseas companies with which we compete do not have 
such an unbalanced system, and their executives do not have their focus diverted 
by having to defend or anticipate these meritless lawsuits. 

There are solutions to this problem. Some that have been proposed today are pro- 
cedural; 4 some are economic, and some are designed to create a disincentive to fil- 
ing meritless suits in the first place. 6 I urge the committee to examine these solu- 
tions, pick the best one or two, and then act. 

If we fail to address this problem, the incentive to innovate will continue to be 
compromised. On the other hand, if we align as many of our systems and processes 
as possible so that American companies can maintain — and sharpen — their competi- 
tive edge, we will strengthen our worldwide technological and business leadership, 
and will continue to offer the most exciting and rewarding employment opportuni- 
ties available anywhere. 

Thank you. 



4 Using the SEC as a "gatekeepter" before suit is filed; requiring early neutral evaluation of 
a claim after the filing, but before massive discovery and legal costs have been incurred; 
strengthen the incentive to early reasonable settlement, through an "offer of judgment" mecha- 
nism which would penalize a party which refused a reasonable settlement offer. 

6 For those cases that are allowed to proceed, setting a methodology for calculating damages 
that is indexed to a market standard, such as the Standard & Poors 500 Index or the 
Hambrecht & Quist Technology Index. 

"Allowing judges the discretion to require payment of attorney's fees by the losing party; dis- 
ciplining attorneys who abuse the system. 



96 





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92,840 



N«w Court Daemons 
ZkitzntAa v. Clark 



1500 5-6-92 



[1 96,603] Zdtxmcn v. Oark, «t d. 

United States District Court. Northern District of California. Civil No. 91-20304 SW. March 
17, 1992. Opinion in full text. 

Exchange Act — Antifraud — Nondisclosures — Scienter.— An investor could not maintain a 
securities fraud action against a company, since there was no basis upon which to draw the inference 
that the company must have known during the first haif of a quarter that the company would not 
meet previously announced expectations for the quarter. A company's statement about its probable 
shipping date in relation to the order date cannot reasonably be used to draw inferences about the 
company's ability to predict its revenues before the end of the quarter. Since the investor did not 
piead a foundation for the inference of scienter, the complaint was dismissed without leave to 
amend. 

See f 22,721 and 22,725, "Exchange Act — Manipulations; National Market System" division. 
Volume 3. 

Milberg Weiss Bershad Specthrie & Lerach, San Diego. Cal.; Berger & Montague, Philadelphia, 
Pa., for plaintiff. 

Wilson, Sonsini, Goodrich k Rosati, Bruce G. Vanyo, Boris Feldman, Jerome F. Birn, Jr., David 
J. Berger and Jotham S. Stein, Palo Alto, Cal., for defendants. 



Opinion of Williams, District Judge. 

During the Persian Gulf war, Plaintiff and 
her proposed class members purchased stock in 
Silicon Graphics. Inc. ("SGI"), a manufacturer 
of computer systems designed to display images 
in three dimensions. When below average earn- 
ings for the quarter caused the price of SGI 
stock to drop from $42.50 to $38.00 per share. 
Plaintiff filed this Rule 10b- 5 action, alleging 
that Defendants predicted strong earnings when 
they knew, or were reckless in not knowing, that 
orders for the quarter were down. Defendants 
move to dismiss the lawsuit contending that 
Plaintiff failed to properly allege (1) false and 
misleading statements or (2) scienter. 

Construing the complaint in the light most 
favorable to Plaintiff, the Court finds that (1) 
the alleged misleading statements were, for the 
most part, not misleading, and (2) there is no 
basis in the complaint for inferring Defendants' 
scienter. Accordingly, Defen dant s' motion to 
dismiss the complaint is GRANTED. 

DISCUSSION 

L THE LAW 

A Fed. R. Civ. P. 12(b)(6) Motion to Dismiss 

Under the liberal federal pleading policies, a 
plaintiff need only give defendant fair notice of 
the claims against it. Canity v. Gibson, 357 US. 
41, 47 (1957). A claim should not be dismissed 
unless it is certain that the law would not per- 

t 96,603 



mit the requested relief even if all of the allega- 
tions in the complaint were proven true. 
Duming v. First Boston Corp., 815 F-2d 1265, 
1267 (9th Cir. 1967). Therefore, for purposes of 
this motion to dismiss, the Court assumes the 
truth of all factual allegations in the complaint 
as well as all reasonable inferences drawn from 
them. 

B. Rule 10b-5 Actions 

Section 10(b) of the Securities Exchange An 
of 1934, 15 U.S.C. § 78j, makes it unlawful to 
use, in connection with "the mails or facilities of 
interstate commerce" any "manipulative or de- 
ceptive device or contrivance in contravention 
of such rules and regulations as the Commission 
may presenbe — " Rule 10b-5 promulgated 
under Section 10(b) provides as follows: 

It shall be unlawful for any person, directly 
or indirectly, by the use of any means or 
instrumentality of interstate commerce, or of 
the mails, or of any facility of any national 
securities exchange, 

(1) to employ any device, scheme, or arti- 
fice to defraud, 

(2) to make any untrue statement of a 
material fact or to omit to state- a material 
fact necessary in order to make the state- 
ments made, in the light of circumstances 
under which they were made, not misleading, 
or 



01992, 



CLwring Hoea*. lac. 



100 



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N«w Court Daemons 
Z*ium*n v. dark 



92,841 



(3) to engage in any act. practice, or course 
of business which operates or would operate as 
a fraud or deceit upon any person, 

in connection with the purchase or sale of any 
security. 

Despite the fact that Rule 10b- 5 says nothing 
about intent to defraud or knowledge of falsity, 
the Supreme Court has ruled that recovery in a 
private Rule 10b- 5 lawsuit requires proof of the 
defendant's scienter. Ernst tnd Ernst v. 
Hochfelder. 425 U.S. 185, 193 (1976); see also 
Aaron v. SEC. 446 U.S. 680 (1980) (scienter also 
required in lawsuit brought by SEC). The 
Hochfelder Court defined this scienter as "a 
mental state embracing intent to deceive, ma- 
nipulate, or defraud." Id. at 194 n.12. The Su- 
preme Court has never decided whether 
recklessness is sufficient to meet the Rule 10b-5 
scienter requirement. 

In the Ninth Circuit, the plaintiff may meet 
the scienter requirement under Rule 10b-5 by 
proving the defendant's recklessness. Hollinger 
v. Titan Capital Corp.. 914 F2d 1564, 1568-69 
(9th Cir. 1990). The Ninth Circuit has adopted 
the Seventh Circuit's definition of recklessness: 

[Rjeckless conduct may be defined as a 
highly unreasonable omission, involving not 
merely simple, or even inexcusable negli- 
gence, but an extreme departure from the 
standards of ordinary care, and which 
presents a danger of misleading buyers or 
sellers that is either known to the defendant 
or is so obvious that the actor must have been 
aware of it. 

Id. at 1569 (quoting Sundstrand Corp. v. Sun 
Chem. Corp.. 553 F.2d 1033/ 1045 (7th Cir.) 
cert, denied. 434 U.S. 875 (1977) (quoting 
Franlce v. Midwestern Okla. Dev. Auth., 428 F. 
Supp. 719, 725 (W.D.Okla. 1976))). 

Therefore, to properly state her Rule 10b-5 
claim, Plaintiff must plead not only false state- 
ments or misleading omissions, but also facts 
which would indicate that Defendants "must 
have been aware" that those statements were 
false or those omissions were misleading when 
made. 

II. ANALYSIS 

In the discussion below, each of Defendants' 
alleged statements and omissions is analyzed to 
determine whether the complaint provides a ba- 
sis for concluding that the statement or omission 
is false or misleading. Then the allegations of 
the complaint are examined to determine 
whether they support an inference of scienter — 
that is, whether the alleged circumstances sug- 
gest that Defendants must have known that 
their statements and omissions presented a dan- 
ger of misleading the investing public. 

Fsdarml SacuritM Law Rcporta 



A. False or Misleading Statements, Omissions, 
and Predictions 

In paragraph 21 of the complaint. Plaintiff 
alleges that, on January 23 and 24, 1991, De- 
fendants provided the following false or mislead- 
ing information to independent stock market 
analysts: 

a) that SGI was expanding its R-3000 line 
of lower cost (under $10,000) products which 
would have a beneficial impact on sales and 
margins; 

b) that SGI's orders had been strong and 
demand remains strong; 

c) that orders for SGI's new high margin 
4D/35 system were strong and that this 
product would start to ship during the Com- 
pany's then-current quarter, 

d) that a reported drop in domestic sales 
was largely due to Federal budget delays in- 
volving the Department of Defense, but that 
this was a temporary measure and that post- 
poned orders were then being placed; 

e) that the Company had taken steps to 
mitigate any disruptions which might be 
caused by the Persian Gulf conflict including 
shifting of production overseas, arranging al- 
ternative transportation means and building 
up inventory; 

that the recent introduction of the Com- 
pany's IRISVISION product would enable 
the Company to generate incremental reve- 
nues of approximately $100 million over the 
next 18 months. 

The complaint does not dispute the technical 
accuracy of most of these statements. For in- 
stance, the complaint does not allege that SGI 
did not expand its R-3000 line of products, and 
there is no basis for concluding that this expan- 
sion did not have a beneficial impact on sales. 
The fact that revenues were down for the third 
quarter does not imply that the R-3000 line of 
products had no benefit — the revenues might 
have fallen further without that line. 

Similarly, the complaint does not dispute that 
orders for SGI's 4D/35 system were strong. The 
complaint concedes that 4D/35 system orders 
were shipped in the third quarter. Complaint, 
f 25(d). The complaint also does not deny that 
Defendants took steps to mitigate disruptions 
caused by the Persian Gulf. Thus, statements 
(a), (c) and (e) are clearly neither false nor 
misleading. 

Indeed, except for Defendants' alleged state- 
ment that "demand remains strong." none of 
the statements regarding historic fact are chal- 
lenged as false. With this one exception, the 
complaint focuses solely on Defendants' predic- 
tions and omissions. All of the alleged predic- 

1196,603 



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1300 5-6-92 



lions are essentially the same — that SGI 
indicated to market analysts and the investing 
public that it expected to enjoy continued pros- 
perity during the third quarter. See Complaint. 
U 21, 22, 23. 4 24. 

In contrast to the statements of historical 
fact, the complaint does provide a basis for 
concluding that the predictions were false, at 
least in the sense that they were ultimately 
incorrect. Therefore, the question is whether the 
complaint supports an inference that Defend- 
ants had the requisite scienter that Defendants 
must neve known that SGI would not enjoy 
continued prosperity. 

The only omission alleged in the complaint 
which is not actually a prediction in disguise 
(see. eg.. Complaint, f 25(c) 4 (d)) is Defend- 
ants' failure to inform the investing public that 
third quarter orders were down when SGI issued 
its second quarter form 10-Q. The question 
again in whether Defendants had the requisite 
scienter: must Defendants have known that the 
failure to provide this information would proba- 
bly mislead the investing public? 

B. Scienter 

With respect to the one allegedly false state- 
ment of fact, the one omission, and the various 
predictions of continued prosperity, Plaintiffs 
entire case for the existence of scienter is based 
on paragraph 18 of the complaint, wherein she 
alleges: 

18. Based on its orders received, SGI is able to 
forecast its sales revenue and income with 
substantial accuracy. As the Company stated 
in its 1990 10-K: 

End users and resellers typically order for 
immediate delivery, and the Company at- 
tempts to ship products within 45 to 60 days 
after receipt of a purchase order. As a result, 
a substantial majority of product shipments 
in a period relate to orders received in that 
period. 

Thus, the company is able to accurately fore- 
cast quarterly revenues and income no later 
than thirty to forty-five days into a quarter. 

Based on this one statement in SGI's 10-K dis- 
closure form, Plaintiffs reason that Defendants 
must have known the third quarter results at 
least 45 to 60 days before the quarter ended 
because any orders taken after that time would 
not be shipped and billed until the fourth quar- 
ter. 

To support this inference. Plaintiff notes that 
SGI announced its third quarter results on April 
3, 1991, only two days after the end of the third 
quarter. Complaint, § 27. Plaintiff reasons that 
SGI must have kept abreast of its financial 
condition if it was able to tabulate its results so 

K 96,603 



soon after the end of the quarter. On this basis. 
Plaintiff concludes that SGI must nave known 
the dollar value of its orders within a day or so 
after they were placed. 

Even if SGI's statement about its shipping 
practice can be used to draw an inference about 
its ability to predict the revenues of any Quar- 
ter, SGI's inferred predictive abilities would not 
have extended to the allegations in paragraph 
21 of the complaint. The allegedly false and 
misleading statements and predictions cited in 
paragraph 21 were made on January 23 and 24, 
1991, only three weeks into the third period or 
seventy days before the end of the third quarter. 
On those dates, under Plaintiffs own reasoning, 
Defendants could reasonably expect to receive 
25 more days of orders that would be billed 
during the third quarter. Thus, it would be 
unreasonable to infer that Defendants must 
have known that third quarter results would not 
be strong. 

The only remaining allegation to support this 
Rule 10b-5 action is the allegation that Defend- 
ants omitted to inform investors in the second 
quarter for 10-Q that the orders received for the 
third quarter were down. Plaintiff urges the 
Court to accept its reasoning that Defendants 
must have known by that time, 49 days before 
the quarter's end, that the omission would prob- 
ably mislead investors into purchasing stock in 
anticipation of SGI's continued prosperity. 

The Court finds that a company's statement 
about its probable shipping date in relation to 
the order date cannot reasonably be used to 
draw inferences about the company's ability to 
predict its revenues before the end of the quar- 
ter. SGI's statement in its 1990 form 10-K was 
not intended to be a statement about the com- 
pany's ability to forecast quarterly revenues. 
There is no indication that SGI is unable to ship 
orders in less than 45 days. Indeed, it is reasona- 
ble to infer that when orders are down the com- 
pany would find it easier to ship products 
earlier. Certainly there would be a motive to do 
so. It is common knowledge that a company 
which is behind in orders during the first half of 
a quarter will attempt to make up the difference 
during the latter half. Therefore, the Court finds 
no basis upon which to draw the inference that 
Defendants must have known during the first 
half of the quarter that SGI would not meet 
previously announced expectations for the quar- 
ter. 

CONCLUSION 

Without pleading a foundation for the infer- 
ence of scienter, Plaintiff cannot properly main- 
tain this Rule 10b-5 lawsuit. If Plaintiff had a 
stronger basis for inferring scienter, she would 
have alleged it. The Court does not wish to 

01992, Commerce Owing House, lac 



102 



1500 544Z » — inTirM 92.843 

2iAaau v. Ou* »*,w-r*p 

undertake further gmrinn in strained r e—. 
i ng. Th eref ore, t he complaint is HEREBY DIS- 
MISSED WITHOUT LEAVE TO AMEND. 

rr IS SO ORDERED. 



103 

PREPARED STATEMENT OF JOHN G. ADLER 

President and Cheif Executive Officer, Adaptec, Inc. 

& Member, American Business Conference 

Mr. Chairman, my name is John G. Adler. I am Chairman and Chief Executive 
Officer of Adaptec, Inc. of Milpitas, California. 

I commend the Subcommittee for holding this hearing on the very serious problem 
of abusive and frivolous class-action securities suits. In testifying here this morning, 
I represent both Adaptec and my colleagues in the American Business Conference 
(ABC), a Washington-based coalition of midsize growth companies with combined 
annual revenues of $42 billion and combined worldwide employment of 450,000 peo- 
ple. 

In addition, the chart accompanying my testimony [Exhibit 1] lists 47 high tech- 
nology companies that wish to be associated with my remarks. In the aggregate, 
these companies have annual revenues of $22.9 billion and employ 134,741 men and 
women. In sum, then, I am here today proudly representing leading-edge American 
firms with total revenues of approximately $65 billion and total employment of 
585,000 people [Exhibit 2]. 

My company, Adaptec, is a leading supplier of high-performance hardware and 
software used to control the flow of data between a microcomputer and its peripher- 
als such as printers, disc drives, and scanners. Our products extract the highest pos- 
sible level of performance from microcomputer systems, thereby enhancing the pro- 
ductivity of computer users. 

Adaptec employs 1,400 people worldwide. They and our customers have made it 
possible for Adaptec to compile 35 consecutive quarters of profitability. Our annual 
revenues for the most recent fiscal year ending on March 31 were $311 million, a 
107 percent increase over the previous fiscal year. Nearly half of those revenues are 
the result of export sales to Europe and the Far East. As you can imagine, this sort 
of sales growth generates jobs: Adaptec currently has 140 openings that we shall 
be filling in the coming months. 

Managing a growth company like Adaptec is a more than full-time job. I have 
nonetheless taken time to come to Washington today to urge you and your col- 
leagues in Congress to consider legislation to address the abuse of class-action secu- 
rities suits. 

Let me say at the outset that I am not for a moment suggesting that all securities 
suits are frivolous or unwarranted. What I am advocating are fair and balanced 
measures designed to cull out cases that are clearly without merit and are filed 
merely to use complicated and protracted procedures to extort money from compa- 
nies and their associated accounting, insurance, and underwriting firms. 

What I am requesting, therefore, is not a legislative wall to block class-action se- 
curities suits. Instead, we need a filter that cleanses the civil justice system of frivo- 
lous claims so that meritorious cases may proceed more expeditiously. 

Many of you are already well aware of the problem of frivolous litigation under 
Section 10(b) of the Securities Exchange Act oi 1934. Briefly, a few law firms have 
made a specialty of representing so-called "professional plaintiffs" in boilerplate 
suits that are typically filed when the price of a company's stock falls. 

These suits allege that management knew or should have known about the price 
decline in advance. The supposed failure of management to communicate that 
knowledge to shareholders before the fact is thus held to be in violation of the law. 
The target company's accounting firm, insurer, and, when possible, underwriter, are 
often named in the suit as waff. These third parties are often put at risk because 
they can assert considerable pressure on the target company to settle the case rath- 
er than hazard a trial. And it is a settlement with its accompanying large contin- 
gency fees that is the ultimate goal of the plaintiffs' attorneys. 

There is not a CEO in the Silicon Valley or any other high technology area who 
does not dread these capricious, abusive suits. Technology companies are especially 
vulnerable because their stock usually sells at a high multiple of earnings. The 
stock price volatility inherent in high P/E ratios creates opportunities for enterpris- 
ing lawyers. 

Having described the problem in a general way, I would like to give this Sub- 
committee a specific example of a frivolous securities suit. It is one I know well 
since it was filed against Adaptec. 

On December 10, 1990, Adaptec held a conference call with securities analysts 
who follow our company. The purpose of the call was to inform these analysts that, 
due to a combination of normal but adverse events, the company's revenues for the 
third quarter of fiscal year 1991 (ending December 28, 1990) would be about 15 per- 
cent lower than the analysts had anticipated in their written reports. We added that 



104 

the company would nevertheless turn in a distinctly profitable performance for the 
quarter. The day following the conference call, December 11, the per share price of 
Adaptec's stock dropped from $15 to $9.88. 

On December 14, we were sued by a law firm notorious for filing class-action secu- 
rities cases. The complaint, which named the company as well as various officers 
and directors, contained generic and completely spurious accusations, alleging activ- 
ity which purportedly began as early as October 10, 1989, exactly one year and two 
months before the conference call took place. In other words, the plaintiffs were 
claiming that Adaptec somehow knew of its disappointing but still profitable quarter 
a full fourteen months before the fact. 

The plaintiffs served written discovery demands comprising over one hundred 
broad-based requests, including such items as "all documents that constitute, dis- 
cuss, or refer to sales or orders in general," and "all documents that discuss or refer 
to profit margins at Adaptec." Worse, these demands were not served on Adaptec. 
Instead, plaintiffs' lawyers served subpoenas on the company's ten most important 
customers and vendors. In the face of this attempt to destroy our key business rela- 
tionships, we had to go to court to force the plaintiffs to obtain the information from 
Adaptec before burdening our customers ana vendors with their demands. 

As a result of the plaintiffs' absurdly broad demands, Adaptec was obliged to 
produce over 1,500 boxes of documents. The cost to the company of this exercise was 
$1.4 million. 

As far as I am concerned, that money was wasted on a glorified fishing expedition 
in search of nonexistent proof of a nonexistent violation of the securities law. Just 
as important, if less readily quantifiable, was the cost in management time. We are 
a lean company. Our ability to compete and grow depends upon the full focus of 
management attention and energy on our business. The written discovery process 
was a crippling diversion of Adaptec's human resources. And today, after more than 
two years with the meter running, we still have yet to enter the deposition phase 
of discovery. 

The suit I have described against Adaptec is not unique; any number of compa- 
nies have had similar experiences. From a public policy standpoint, which is obvi- 
ously your area of concern, there are three reasons why I believe you should take 
action to filter out such frivolous litigation from the civil justice system. 

First, and of particular interest to this subcommittee, is the chilling effect such 
suits have on corporate communications to the financial community. Open and fre- 
quent communications are essential if the financial markets are to operate effi- 
ciently. But I must tell you in all candor that nothing that Congress and the Securi- 
ties and Exchange Commission do to encourage such communications can overcome 
the opposite pressure exerted by the fear of securities suits on corporate manage- 
ment. 

Many firms in Silicon Valley, and, I suppose, elsewhere, have adopted a "no com- 
munications" policy. That means they say nothing beyond what they must disclose 
by law. That strategy limits the ability of investors to make informed choices and 
seems to me wrong as a matter of principle. Nevertheless, "no communications" 
makes perfect sense if the goal is to avoid situations that might lead to a class-ac- 
tion suit. 

Second is the extent to which abusive securities suits impede corporate governance. 
At a time when policymakers are urging the boards of publicly-held companies to 
take on greater responsibilities, it is becoming much more difficult for firms — par- 
ticularly smaller companies — to find qualified people to serve on their boards. The 
reason is simple: the prospect of being sued. 

Adaptec currently has one unoccupied board position. You might think, given our 
financial record and given the cachet of Silicon Valley, that we would have no prob- 
lem filling that seat. In fact, I have thus far invited three people to join the board 
and all three in turn have refused. They left no doubt about why they demurred: 
they feared being embroiled in a class-action suit. This problem is not unique to 
Adaptec. Seventy-one percent of the chief executives in the American Business Con- 
ference report that they have found it more difficult to attract directors because of 
potential liability from litigation. 

ABC members themselves are reluctant to join corporate boards. Sixty percent say 
that the litigation issue has forced them to weigh more carefully their decision to 
join a corporate board. Another 24 percent refuse service on corporate boards of 
start-up firms or other companies vulnerable to securities litigation. Seven percent 
refuse to join corporate boards of any sort. I am among that seven percent. 

Abusive securities suits are robbing a generation of new firms of the outside man- 
agerial know-how that companies desperately need in their formative stages. And, 
in a larger sense, the inability of companies of all sizes to obtain competent board 
members means that the board of directors as an institution will continue to fall 



105 

short as a vehicle for improving corporate performance and insuring management 
accountability to shareholders. 

Third, and most important, is the adverse effect of abusive securities suits on 
American competitiveness. By competitiveness I mean the capacity of companies to 
grow, to enter new markets, to pursue new ventures, and to create new jobs. Frivo- 
lous litigation has an obvious detrimental effect upon these elements of competitive- 
ness. 

In my company's case, the $1.4 million pre-discovery expenses we incurred could 
have been used to hire a dozen engineers. And, of course, there is no way to gauge 
the opportunity costs such a suit entails. We have been fighting this battle for over 
two years and while our financial results during that period have been superb, I 
cannot help but wonder what we could have done had this weight not been placed 
on our collective shoulders. 

Members of Congress are debating this year over the need for new taxes and new 
regulations on business. I suppose that part of the reason for the intensity of the 
debate is your realization that when government adds to the cost of doing business, 
firms function less well and hire fewer people. In that context, you should think of 
abusive securities litigation as a particularly onerous cost of doing business — a liti- 
gation "tax" — that brings no countervailing benefits. That we allow this sort of activ- 
ity to continue is, in my opinion, a national disgrace. 

As you consider how to mitigate the problem of abusive securities suits, I believe 
you would be wise to begin with the bill Senators Domenici and Sanford introduced 
last year, S. 3181. This bill is a model for what I think should be done. (Similar leg- 
islation — H.R.417 — has already been introduced in the House this year by Rep- 
resentative Tauzin and others.) 

S. 3181 was not a "kill-all-the-lawyers" bill; it attempted instead to create the sort 
of filter I think we need to purify the system of frivolous suits. Thus, while S.3181 
proposed to change certain features of current procedure that encourage frivolous 
securities litigation, it simultaneously would have extended the statute of limita- 
tions for 10(b)(5) claims. That sort of balance, which limits frivolous suits while wid- 
ening the courthouse door for more substantive cases, is precisely the goal this sub- 
committee should seek. 

To curtail frivolous suits, S.3181 offered three main reform ideas: proportionate 
liability, modified fee shifting pertaining exclusively to suits found to be not sub- 
stantially justified, and the elimination of abusive litigation practices. All seem to 
me desirable; none is sufficient alone. 

Indeed, I would invite the subcommittee to consider two other proposals that, 
based on my experience, would help to solve the problem. First, I would recommend 
legislative language that would require plaintiffs to show some basis for claims of 
fraud before they can initiate a suit. The earlier the system filters out frivolous 
cases, the less waste such cases cause. 

And, second, I think you should try to find ways to place reasonable time and cost 
limits on pretrial discovery. As it now stands, the discovery process is a nightmare 
straight out of Dickens. 

Please take these as starting points for forging your own, better reform ideas. I 
am not a lawyer and I did not come to Washington to tell you how to write legisla- 
tion. 

My job is to convince you that there is a serious problem with frivolous securities 
litigation and that you have a responsibility for solving it. I know there are political 
risks inherent in taking on this task. I ask you to believe that there are risks inher- 
ent in simply talking about this problem at a Congressional hearing. I sometimes 
feel as if I have pinned a big sign on my back saying "Sue Me." 

But, Mr. Chairman, I know something about taking risks. I came to this country 
as a refugee from Eastern Europe, knowing not a word of English. Without risk, 
I would not be where I am. 

It is in that spirit that I come here today. I and the other businesspeople I rep- 
resent are not looking for special treatment. We are not asking for protection from 
all lawsuits. We ask only that we not be burdened with defending against predatory, 
frivolous suits that make it even more difficult to be competitive in an already tough 
economic environment. Thank you. 



106 

EXHTBIT 2 

TOTAL ANNUAL REVENUES AND WORLDWIDE EMPLOYMENT 
OF REPRESENTED COMPANTES 



LISTED HIGH TECH COMPANIES 
REVENUES $ 22.9 b 
EMPLOYMENT 134, 741 

ABC COMPANIES 
REVENUES $ 42 b 
EMPLOYMENT 450,000 

TOTAL REVENUES $ 65 b 
TOTAL EMPLOYMENT 585,000 



107 



v 



EXHIBIT 1 



HIGH TECHNOLOGY COMPANIES ENDORSING 
TESTIMONY OF JOHN G. ADLER 



3Com 

ACTEL 

Adaptec 

Advanced Logic Reseach 

Advanced Micro Devices 

Altera 

Auspex Systems 

Autodesk 

Cadence Design Systems 

Centigram 

Communications 
Chips and Technologies 
Cirrus Logic 
Compression Labs 
Conner Peripherals 
Cypress Semiconductor 
Cyrix 
Distributed Processing 

Technology 
Exabyte 

Hal Computer Systems 
Informix Software, Inc. 
Intel 
International 

Microelectronic Products 
Komag, Inc. 



Linear Technology 

Logical Services 

Maxtor 

NetFRAME Systems 

Network General 

Orbit Semiconductor 

Qume 

Radius 

RasterOps 

S-MOS Systems 

S3 

Seagate 

Sierra Semiconductor 

Software Publishing 

SyQuest Technologies 

Tech Data 

The Santa Cruz 

Operations 
Trident Microsystems 
Weitek 
Wyle Labs 
Xilinx 
Xylogics 
Zeos 
Zilog 



108 

PREPARED STATEMENT OF RICHARD J. EGAN 
Chairman of the Board, EMC Corporation 

Mr. Chairman, and Members of the Subcommittee, I thank you for this oppor- 
tunity to express my views and deep concerns about the devastating and debilitating 
effect of securities fraud lawsuits on publicly-traded companies, particularly those 
in the high technology arena. 

My name is Richard J. Egan. I am Chairman of the Board, Founder, and a Direc- 
tor of EMC Corporation of Hopkinton, Massachusetts. EMC designs, develops and 
manufactures high performance computer storage systems which improve the capac- 
ity and performance of large- and medium-sized computer systems and hence the 
productivity of our Customers. 

We employ approximately 1,600 people, and operate 60 Field Offices around the 
world. Our revenues last year were $349 million, over 30 percent of which was de- 
rived from sales made outside the United States. 

Like so many high technology companies, EMC started small. My co-founder, 
Roger Marino, and I pooled our savings and extended our credit card limits to the 
maximum to fund EMC's start-up in 1978. Thanks to some hard work, a lot of luck, 
and a great interest in our products, we grew at such a rapid rate that by 1986 
we were obliged to raise new capital through the equity markets. 

Two Frivolous Lawsuits 

Since becoming a public company, we have been the target of two lawsuits that 
I call "strike" suits, because as I have since learned they are typically filed within 
days or sometimes hours of a company's announcement of adverse news or "dis- 
appointing" earnings — and they are intended to coerce the company into settlement. 

The first lawsuit, which was filed in 1988, was initiated by a Philadelphia law 
firm on behalf of a fellow who I later learned was a professional investor and a part- 
ner in a money management firm. 

This lawsuit was prompted by an announcement by EMC that our quarterly earn- 
ings would be lower than they were in the previous quarter. Our legal counsel ad- 
vised us that our management had not acted in any improper or illegal manner, but 
that it would be expensive to defend ourselves. Because we were still a small com- 
pany, and because we could have been completely wiped out by an adverse court 
ruling, I decided, very reluctantly, that we would settle the case. 

As a result of this strike suit, management decided that we would in the future 
limit public information about EMC and its progress and expectations. You see, the 
reason class-action suits are usually filed immediately after a public announcement 
by a company is so the plaintiffs' lawyers can beat each other to the courthouse and 
be the first to file suit. That is because the lead attorney stands to gain the greatest 
share of the legal fees. One study reported that of 46 cases it studied, 12 were filed 
within one day and 30 within one week of the publication of unfavorable news about 
the defendant company. 1 Obviously, since these suits are filed so quickly, there is 
no time for any factual investigation about whether fraud was actually committed. 
Instead, once the suit is filed, the plaintiffs law firm proceeds to search through 
all of the company's documents and take endless depositions for the slightest posi- 
tive comment which they can claim induced the plaintiff to invest and any shred 
of evidence that the company knew a downturn was coming. 

Although the Securities and Exchange Commission continues to press public com- 

Eanies for maximum disclosure, these strike suits have exactly the opposite effect, 
fow, we always have a defensive posture to our statements because of the concern 
that we will get sued. In addition, companies can be reluctant to take the business 
risks that often must be taken in our industry to seize opportunity if every time 
a risky project fails the company is sued for "fraud." 

Our second "strike" suit was filed against EMC in 1991. It followed by only 20 
hours — less than one day — our public announcement that quarterly results, which 
had been increasing steadily, would show less profitability than the prior quarter. 
We were not reporting an actual loss, only a decline in earnings growth. 

By the time this second strike suit was filed, we were big enough to defend our- 
selves and we still remembered how outraged we were at the first suit. We were 
fortunate in that we argued before a very sophisticated and intelligent judge that 
took the time to understand the case and who saw through this charade. 

A copy of the court's decision in this case will be submitted for the record to the 
subcommittee, but, in brief, in March 1992 a Federal judge dismissed the lawsuit 
"with prejudice," and chastised the plaintiffs because they, in the judge's words, "ap- 
parently wish to embark on a fishing expedition at the defendants expense." 



^They've Contend the Market, National Law Journal, April 27, 1992. 



109 

Nevertheless, EMC management and its attorneys spent an enormous amount of 
time in defending this thoroughly meritless lawsuit. Needless to say, distracted 
management time cost us sales and planning for the future. 

Mr. Chairman, I have since learned that such "fishing expeditions" are not un- 
common. Apparently, there are a number of law firms that specialize in filing claims 
against high tech companies such as EMC that often have unpredictable earnings. 
Usually, as I understand it, these law firms rely on a cadre of "professional" plain- 
tiffs that own only a few shares of many public companies ana who are solicited 
by the law firms when a plaintiff is needed. I understand that one individual, a re- 
tired attorney, has been a plaintiff in over 300 lawsuits. The lead plaintiff in a class- 
action suit can be awarded a substantial bonus just for lending his name to the com- 
plaint. 2 The plaintiffs in our case were two persons who, collectively, owned only 
a minimal amount of our stock. 

These law firms monitor the stock "Quotrons" and often compare the price of a 
company's stock with the Standard & Poor's index. When they detect a sharp diver- 
gence, they file a lawsuit. Many of these lawsuits are frivolous, and are little more 
man witch hunts that cost a company enormous time and money. And the plaintiffs 
lawyers are not obliged to produce any evidence — only a complaint alleging that the 
defendant company may have made overly optimistic — or even in some cases, overly 
pessimistic — statements about its progress. There is little downside risk for the 
plaintiffs' lawyers. Once a suit is filed, they are practically guaranteed a windfall 
in legal fees since, as they are well aware, virtually all of these lawsuits are settled 
with the companies paying the plaintiffs and their attorneys to, in effect, go away. 

And, by the way, Mr. Chairman, the attorneys receive a large chunk of the settle- 
ment funds. The investor plaintiffs receive very little. It seems that the current sys- 
tem works primarily to the benefit of the lawyers involved. 

Implications for Public Companies, Investors and the U.S. Economy 

If these strike suits are allowed to continue unrestrained, I believe that several 
unfortunate consequences will result. Among them: 

• Companies will be reluctant to publish forecasts despite the SEC's requests to do 
otherwise. As a result, investors will have less information upon which to make 
their investment decisions. 

• Companies will not take sound risks but will manage their operations so as to 
maintain steady performance and avoid stock fluctuations, thereby eliminating op- 
portunities for innovation, growth, new jobs, and long term investment. 

• The Corporate decision-making process will be severely hampered by the need to 
scrutinize every management action that might possibly become the subject of a 
lawsuit, however frivolous. 

• Companies will pay enormous sums to law firms — and not to their investors, and 
will also be limited in their ability to increase jobs and to invest in new plants 
and equipment. 

• Management time will be diverted to defend against these lawsuits — as well as 
spendmg time positioning a company's actions to avoid them. 

• And it places U.S. Corporations at an unfair disadvantage because we must con- 
stantly think "short-term" in order to deliver acceptable financial results every 90 
days rather than focusing on the long-term development of new technologies and 
processes. A disadvantage with which most of our foreign competitors do not have 
to contend. 

Remedying the Situation 

Mr. Chairman and Members of the subcommittee, I firmly believe that American 
industry must be efficient and productive if it is to remain competitive in a global 
economy. Any time and money that is not spent on improving products, quality con- 
trol and assurance, employee training, and other important areas hampers this im- 
eortant objective — and does so at the expense of the private investor and share- 
older. 

But there are some steps that I believe Congress can take to alleviate this trou- 
bling situation. 

• First, plaintiffs and plaintiffs' legal counsel should be required to pay the legal 
costs and expenses of defendants in cases which are found not to have been un- 
justified. 

• There should be a standard of "clear and convincing" proof for allegations of fraud 
against companies. This would discourage lawsuits based on statements by a com- 



2 Being a Plaintiff Sometimes Amounts to a Profession, by Andrew Leigh, Investors Business 
Daily, Nov. 1, 1991; The Professional Plaintiffs, American Lawyer, Dec. 1989. 



110 

party that turned out to be inaccurate but that were not intended to mislead in- 
vestors or the public. 

• Plaintiffs should not be "invisible," and they should not be allowed to become "pro- 
fessional," that is, appear as plaintiffs in lawsuit after lawsuit. In addition, con- 
tacts and arrangements with plaintiffs and their law firms should be made discov- 
erable. 

• The American Bar Association should be urged to track and investigate the activi- 
ties of law firms that engage in repeated strike suits, and to establish criteria for 
defining and publicly identifying those firms who repeatedly file frivolous suits. 
Before concluding, I wish to relate to you a recent conversation I had with the 

president of Seagate Technology, a company that produces computer disk drives. 
This market, which is now dominated by American companies, is very competitive 
and the companies involved are known to experience very volatile sales and earn- 
ings results. 

My colleague told me that his firm was a defendant in a strike suit — his third. 
I said, "So what else is new?" He replied, This time they sued me because our stock 
price went up!" By the way, this suit was filed by the same law firm that simulta- 
neously was suing him in another suit because the company's stock had gone down. 3 

This story might be funny were it not indicative of a terrible threat to American 
companies, to our economy and to our Nation's competitiveness around the world. 

I thank you for your attention and interest. I would be pleased to answer any 
questions you may have. 



STATEMENT OF F. THOMAS DUNLAP, JR. 
Vice President, General Counsel and Secretary, Intel Corporation 

1. Intel: High Technology Company 

I am the General Counsel of Intel which is a high technology company based in 
Santa Clara, California, with major manufacturing facilities in New Mexico, Arizona 
and Oregon. Intel's product line is centered around the microprocessor which you 
can think of as the brains of many of today's computers. In order to compete inter- 
nationally in this business, in 1993 we expect to invest over $900M in research and 
development and over $1.2B in capital equipment. Historically, high technology 
companies like Intel have been associated with a significant amount of risk due to 
the nature of developing technology and forecasting sales of emerging markets. So 
high tech companies often have had a lot of volatility in our stock price. 

2. Intel Growth 

Actually, Intel is one of the more stable technology companies. This year we will 
celebrate our 25th anniversary. If you follow our stock price on a daily or weekly 
basis, you can certainly see there is a lot of short term volatility in the price of Intel 
stock. However, over the years, the stock has steadily grown and particularly over 
the last two years, the stock has gone from as low as $23.50 in August of 1991 to 
$56.50 as of last Friday. Our earnings per share have gone from $0.48 in Ql/91 to 
$1.24 in Ql/93 (All numbers adjusted for a 2:1 stock split). Nevertheless, during 
that two-year period, we have been sued in seven separate lawsuits involving two 
stock price drops for various alleged securities violations. All of the seven suits were 
meritless lawsuits. 

3. 9/91 Litigation 

In September of 1991, we internally determined and immediately announced to 
the market that we expected that our third quarter revenues and earnings would 
significantly lower than Intel or the market in general expected. The stock dropped 
from $24.88 to $20.75 and within 48 hours three lawsuits were filed. Of course, 
there is no way that before September we could have predicted that our earnings 
or revenues were going to fall off. As a result of the lawsuits, we had to begin an 
extensive search for documents, had to interview a large number of executives, and 
we had to produce a large volume of documents to the plaintiffs attorneys. In short, 
we were required to spend a lot of money on legal fees. After we collected all the 
documents, we pent the plaintiffs attorneys what we referred to as a "Rule 11 Let- 
ter." Rule 11 is intended to prevent lawyers from filing frivolous lawsuits. We ex- 
plained why there was no violation of the securities laws and gave the plaintiffs a 



3 An article detailing the experiences of Seagate Technology and other California high tech 
companies with strike suite is attached. Securities Class Action Scandal by Nancy Rutter, Up- 
side, April 1990. 



Ill 

chance to drop the suit before we proceeded with sanctions under Rule 11. The 
plaintiffs dropped the lawsuit. We did not pay a penny in damages but, of course, 
we wasted a lot of management time and legal fees. 

4. 4/93 Litigation 

In April of 1993, a judge granted one of our competitors a new trial 10 months 
after a jury verdict in Intel's favor. Once again the stock dropped and once again 
within 48 hours we were sued. On the day T>efore the market learned that a new 
trial was ordered, Intel stock closed at $55.00. It opened at $50.25 the next day and 
closed over $48.00. It recovered to $51.38 two davs later and has traded as high as 
$60.00 since then. We expect these cases to follow the same pattern as the 1991 
cases. 

5. Expenses 

These two lawsuits, should never have been brought. It didn't cost the plaintiffs 
anything, but it cost Intel a lot of lost management time and over $500,000.00 in 
legal fees. The legal fees could have paid the salaries of 10 production workers in 
our new Albuquerque facility or 5 engineers for a year. 

I hope these two examples identify the need for legislation to curb frivolous law- 
suits such as these. 

It is our belief that cases such as these are often filed with no factual basis for 
the allegations other than a drop in the price of the stock. These litigation practices 
are tantamount to the "greenmail" practices that received such wide coverage in the 
financial press of the 1980's, in that many companies don't have the resources to 
fight the lawsuits, and consequently, may find it less expensive to settle their cases 
for damages than to defend themselves in court. This practice of settling merely en- 
courages the filing of even more cases on even more flimsy factual grounds. 

It is time to pass legislation to discourage the filing of these types of frivolous se- 
curities litigation. 



TESTIMONY OF WILLIAM R. McLUCAS 

Director, Division of Enforcement 

United States Securities and Exchange Commission 

Chairman Dodd, and Members of the Subcommittee: I appreciate this opportunity 
to appear on behalf of the Commission to discuss issues related to private litigation 
under the Federal securities laws. 

The strength and stability of our Nation's securities markets depend in large part 
on investor confidence in the continued fairness and efficiency of those markets. In 
order to maintain this confidence, it is important that investors have effective rem- 
edies against persons who violate the antifraud provisions of the Federal securities 
laws. Although the Commission devotes substantial resources to the detection and 
prosecution of securities law violations, private actions under Section 10(b) of the 
Securities Exchange Act of 1934 serve as the primary vehicle for compensating de- 
frauded investors. Private actions also provide additional deterrence against securi- 
ties law violations. 

Ideally, a system of private securities litigation would ensure that defrauded in- 
vestors receive full compensation for their losses and that defendants pay nothing 
on frivolous claims. In practice, of course, any system of civil litigation will depart 
from this ideal. Securities litigation, in particular, is a costly endeavor, and the par- 
ties are faced with inherent uncertainty about outcomes. As a result, plaintiffs often 
settle meritorious claims for less than their full value, and defendants may settle 
claims for which they have valid defenses. 

These hearings are being held because a number of parties, including the account- 
ing profession, m particular, believe that abuses of the system have become so prev- 
alent that Congress must enact legislation that would curtail meritless securities 
litigation. Citing what they describe as a 'litigation explosion," the proponents of 
litigation reform proposals have argued that the cost of defending a securities fraud 
action is so high — and the potential liability so great — that defendants are coerced 
into settling cases that they almost certainly would win at trial. 1 The proponents 



1 See, e.g., Public Oversight Board, SEC Practice Section, American Institute of Certified Pub- 
lic Accountants, In the Public Interest: A Special Report on Issues Confronting the Accounting 
Profession (Mar. 5, 1993) [Hereinafter POB Report]; Arthur Andersen & Co., et al., Liability Cri- 
sis in the United States: Impact on the Accounting Profession— A Statement of Position (August 

Continued 



112 

also cite studies which suggest that settlements in class-action securities cases gen- 
erally are not based on the merits. 2 

The Commission itself has recognized the dangers posed by meritless securities 
litigation. 3 There is a strong public interest in eliminating meritless cases because, 
to the extent that baseless claims are settled solely to avoid the cost of litigation, 
the system imposes what may be viewed as a tax on capital formation. For that rea- 
son, reasonable legislative reforms that are tailored specifically to deter meritless 
actions deserve consideration. 

It is important to recognize, however, that the issues under consideration are com- 

Slex, and that any legislation in this area must be drafted carefully to preserve the 
enefits of private securities legislation. It is especially important to recognize that 
certain of the proposals included under the rubric "litigation reform," such as pro- 
portionate liability or changes in the standards for aiding and abetting liability, go 
far beyond other measures that would affect only baseless claims. Such proposals 
would fundamentally alter private securities fraud litigation by changing either the 
standard for secondary liability, or the consequences of such liability. If enacted, 
these proposals could make it impossible for defrauded investors who prevail at trial 
to recover full compensation for their losses. 

Given the fundamental importance of private actions, litigation reform legislation 
should be approached with caution. It would be unfortunate if legislation intended 
to "reform" the system led to an erosion of investor safeguards. This Subcommittee 
will need to examine the nature and scope of the alleged problem, separate fact from 
rhetoric, and consider the consequences that each reform proposal might have on 
the existing financial reporting and disclosure system. Although meaningful reform 
is possible, it should not be made at the expense of existing protections against de- 
liberate fraud. 

The Commission's Enforcement Program 

The Commission has many responsibilities under the Federal securities laws, but 
law enforcement is one of its most important missions. Approximately one-third of 
the Commission's budget is devoted to its enforcement program, which is carried out 
by the Division of Enforcement and each of the Commission's nine regional offices. 
The enforcement program is designed to protect investors and foster investor con- 
fidence by preserving the integrity and efficiency of the securities markets. In order 
to meet these goals, the Commission seeks to maintain an active enforcement pres- 
ence in each of the areas within its jurisdiction. 

Most of the Commission's enforcement resources are devoted to the most serious 
forms of securities fraud — theft of investor funds, penny stock fraud, insider trading 
and fraudulent financial disclosure. Financial fraud, in particular, is the type of vio- 
lation that most often results in private securities class-action litigation. In coordi- 
nation with the Division of Corporation Finance and the Office of the Chief Account- 
ant, the Division of Enforcement maintains an active program to identify companies 
that violate the disclosure requirements and prosecute the persons responsible for 
those violations. 

Last year, 69 of the Commission's approximately 395 enforcement actions pri- 
marily involved financial disclosure or accounting issues. These types of cases aver- 
aged roughly 15 percent of the enforcement actions brought by the Commission over 
the last ten years. Financial fraud investigations usually require a commitment of 



6, 1992) [hereinafter Liability Crisis Paper]; J. Michael Cook, et al., Financial Reporting and 
the Accounting Profession— Statement of Position (April 19, 1993) [hereinafter Financial Report- 
ing Paper]. 

* See Janet Cooper Alexander, Do the Merits Matter? A Study of Securities Class Actions, 43 
Stan. L. Rev. 497 (1991) (finding that the strength and merits of a group of cases involving com- 
puter companies sued following initial public offerings was not reflected in the settlement 
amount in those cases). 

Other studies examining a broader range of securities class-action cases have not reached the 
same conclusions. See Frederick C. Dunbar, National Economic Research Associates, Inc., Recent 
Trends in Securities Class Action Suits, at 6 (Aug. 1992) (suggesting first, that the "increased 
dispersion of settlements, relative to investor losses, reduces the evidence that the merits don't 
matter" and second, that officers' and directors' liability insurance "may help to explain both 
the low percentage of settlements to investor losses and the even lower ratio which exists for 
claims involving very large investor losses"); Vincent E. O'Brien and Richard W. Hodges, A 
Study of Class Action Securities Fraud Cases, at II— 3 (1991) (finding the settlement as a per- 
centage of losses varied between 0.7 percent and 18.3 percent in a group of 20 securities class 
actions). 

3 See Testimony of Richard C. Breeden, Chairman, Securities and Exchange Commission, 
"Concerning the Securities Investors Legal Rights Act of 1991," before the Subcommittee on 
Telecommunications and Finance, House Committee on Energy and Commerce, Nov. 21, 1991, 
at 14. 



113 

substantially more resources than other types of investigations. This is principally 
due to the complexity of such cases, which are document-intensive and demand the 
expertise of attorneys, accountants, and often financial analysts or economists. 

Over the past decade, Congress has enacted legislation that has greatly enhanced 
the strength and flexibility of the Commission's enforcement remedies. The Securi- 
ties Enforcement Remedies and Penny Stock Reform Act of 1990, in particular, has 
improved the Commission's ability to deal appropriately with financial disclosure 
violations by enabling it to seek civil money penalties and by providing an adminis- 
trative cease-and-desist remedy. 

It is important to remember, however, that while the Commission attempts to 
pursue all of the most egregious financial fraud cases, 4 it does not have the re- 
sources to investigate every instance in which a public company's disclosure is ques- 
tionable. This would continue to be the case even if the Commission's resources were 
substantially increased. The Commission must select certain cases to pursue based 
on the type of violation and the egregiousness of the conduct. Our pursuit of these 
cases permits us, in turn, to discourage similar violative conduct in the most cost- 
effective manner. 5 

The Importance of Private Actions 

Due to the Commission's inability to address all violations, the implied private 
right of action under Section 10(b) and Rule 10(bX5) thereunder is critically impor- 
tant to the effective operation of the Federal securities laws. As the Supreme Court 
has stated repeatedly over the last thirty years, private actions under the Federal 
securities laws are a "necessary supplement" to the Commission's own enforcement 
activities. 6 Given the continued growth in the size and complexity of our securities 
markets, and the absolute certainty that persons seeking to perpetrate financial 
fraud will always be among us, private actions will continue to be essential to the 
maintenance of investor protection. 

Private securities fraud actions also serve another important function that Com- 
mission enforcement actions cannot replace. When the Commission files an enforce- 
ment action, its principal objectives are to enjoin the wrongdoer from future viola- 
tions of the law, to deprive violators of their profit by seeking orders of 
disgorgement, 7 and generally to deter other violations by seeking civil money pen- 
alties. Although the Commission usually makes disgorged funds available for the 

*See, e.g., Securities and Exchange Commission v. Sahlen, Civ. No. 92-7257 (S.D. Fla.), Lit 
Rel. No. 13480, AAER No. 436 (Dec. 21, 1992) (involving Sahlen & Associates >, Securities and 
Exchange Commission v. Ronkin, Civ. No. 92-0979 (D. D.C.), Lit. Rel. No 13227, AAER No. 371 
(Apr. 24, 1992) (involving College Bound, Inc.); Securities and Exchange Commission v. Wiles, 
Civ. No. 91-1393 (D. Colo.), Lit. Rel. No. 12942, AAER No. 308 (Aug. 14, 1991) (involving 
Miniscribe Corp.); Securities and Exchange Commission v. Minkow, Civ. No. 90-4361 (HLH) 
(CD. Cal.), Lit. Rel. No. 12579 (Aug. 15, 1990) (involving ZZZZ Best Co.); Securities and Ex- 
change Commission v. Towle, Civ. No. C 90-1505-EFL (N.D. Cal.), Lit Rel. No. 12484, AAER 
No. 258 (May 24, 1990) (involving Thortec International, Inc.); Securities and Exchange Commis- 
sion v. Antar, Civ. No. 89-3773 (D. N.J.), Lit Rel. No. 12239, AAER No. 247 (Sept 6, 1989) 
(involving Crazy Eddie, Inc.). 

"One minor amendment to the Federal securities laws that would enable the Commission to 
use its resources more efficiently would be a provision authorizing a Federal district court, in 
an action or proceeding initiated by the Commission, to authorize the parties to serve witnesses 
with subpoenas in any district in which the witness is found. Although the Commission cur- 
rently has the authority in its investigations to subpoena witnesses and compel their attendance 
anywhere in the United States, it does not have any similar ability to subpoena witnesses na- 
tionwide in Federal court actions. As a result the Commission's staff often must travel around 
the country taking depositions of witnesses who have already testified in an investigation, be- 
cause it cannot subpoena those witnesses to testify at trial. 

*Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 111 S. Ct 2773, 2789 (1991); Bate- 
man Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 309 (1985); Blue Chip Stamps v. Manor 
Drug Stores, 421 U.S. 723, 730 (1975); J.I. Case Co. v. Borak, 377 U.S. 426, 432 (1964). 

7 It is important to distinguish disgorgement from restitution or damages. In contrast to dam- 
ages granted in private actions, which are designed to compensate fully the victims of a viola- 
tion, disgorgement "is a method of forcing a defendant to give up the amount by which he was 
unjustly enriched." Securities and Exchange Commission v. Blavin, 760 F.2d 706, 713 (6th Cir. 
1985); Securities and Exchange Commission v. Commonwealth Chemical Secur., Inc., 574 F.2d 
90, 102 (2d Cir. 1978). In a few exceptional circumstances, the Commission has pursued restitu- 
tion remedies, which aim at compelling the wrongdoer to make all victims whole. These have 
usually been securities offering cases in which the enterprise was alleged to be a virtual sham. 
See, e.g., Securities and Exchange Commission v. Current Financial Management, Civ. No. 91- 
3089 (D.D.C.), Lit Rel. No. 13112 (Dec. 2, 1991); Cf. Securities and Exchange Commission v. 
Wymer, Civ. No. 91-6715, Lit. Rel. Nos. 13635, 13389 and 13164 (May 12, 1993) (restitution 
ordered against investment advisor). 



114 

compensation of injured investors, 8 the amount of investor losses often exceeds the 
wrongdoer's ill-gotten gains. Private actions, by contrast, enable defrauded investors 
to seek compensatory damages and thereby recover the full amount of their losses. 

Due to their critical role in the disclosure process, accountants are among the par- 
ties most frequently sued in private actions. Although an issuer (through its officers 
and directors) bears primary responsibility for ensuring that its financial disclosure 
is both accurate and complete, registration statements filed under the Securities Act 
and annual reports filed under the Exchange Act are required by statute to include 
financial statements audited by an independent accountant. The Supreme Court has 
described accountants as serving a "public watchdog" function, in which they "as- 
sume a public responsibility transcending any employment relationship with the cli- 
ent." 9 

In light of the concerns expressed by the accounting profession and others, it is 
first appropriate to determine the extent to which private actions have been abused, 
and then to consider measures that might reduce the number of meritless lawsuits. 
Given the importance of private actions, however, litigation reform should seek to 
eliminate frivolous claims and abusive litigation without diluting the effectiveness 
of private remedies against fraud. There is a substantial danger that market con- 
fidence will be eroded if investors are unable to vindicate their rights whenever pub- 
lic companies or their professional advisers fail to discharge their responsibilities 
under the law. 

Assessing the Need for Litigation Reform 

The proponents of litigation reform suggest that our legal system is in the midst 
of an unprecedented litigation explosion. ° Accountants, in particular, have been 
voicing concerns for many years about the threat posed by the continuing "liability 
crisis to their profession. 11 While there is no question that these concerns are genu- 
ine, it is essential to obtain the data that is needed to assess the extent of the litiga- 
tion crisis and evaluate the type of legislation urged by the profession. 

The Commission's staff has attempted to determine the extent to which private 
litigation under the Federal securities laws (as opposed to litigation under state neg- 
ligence laws) presents a "crisis " as well as the extent to which Federal courts need 
additional remedies to deal with meritless cases. Thus far, the available information 
has been inconclusive. According to statistics obtained from the Administrative Of- 
fice of the U.S. Courts, for example, the approximate aggregate number of securities 
cases (including Commission cases) filed in Federal district courts does not appear 
to have increased over the past two decades. 12 Similarly, while the approximate 
number of securities class actions filed during the past three years is significantly 
higher than during the 1980's, the numbers do not reveal the type of increase that 
ordinarily would be characterized as an "explosion." 13 (See Appendix A) 

On September 21 of last year, the Commission's Chief Accountant sent a detailed 
request for information to the "Big Six" accounting firms. The letter asked each of 
the firms to provide, among other things, information for each of the five preceding 



8 Unlike disgorgement, the Commission is required to turn over penalties collected to the U.S. 
Treasury. See, e.g., Exchange Act § 21A(dXl). 

B United States v. Arthur Young & Co., 465 U.S. 805, 818 (1984). 

10 See, Liability Crisis Paper, supra note 1. 

11 See. e.g., N. Minow, Accountant Liability and the Litigation Explosion, 76 J. Acct. 70 (Sept. 
1984) (The number of lawsuits against accountants has soared, the damages awarded have sky- 
rocketed and novel theories of liability are imposed by the courts. More lawsuits have been filed 
against accountants in the last decade and a half than in the entire previous history of the pro- 
fession."). 

See also, Testimony of Ray J. Groves, Chairman, American Institute of Certified Public Ac- 
countants, Special Committee on Accountants' Legal Liability, on The Accounting Profession's 
Perspective on the Liability Insurance Crisis, Before the Subcommittee on Oversight and Inves- 
tigations of the House Committee on Ways and Means (March 24, 1986), at 2, which states: The 
trends that have increased the exposure of accountants to liability for alleged audit defects and 
contributed to the increasingly unstable insurance market pose a grave threat to the economic 
viability of the accounting profession. What is at stake is the ability of the profession to continue 
fully to serve the public's need for competent and objective financial reporting in the face of in- 
creasing liability exposure. 

12 Although the number of filings increased substantially during the mid to late 1980's, it sub- 
sequently declined to prior levels. 

"The Administrative Office of the U.S. Courts combine securities filings in Federal court with 
filings in commodities and exchanges cases. Thus, our interpretation of this data is based upon 
the assumption that the vast majority of filings reported are securities cases. In addition, and 
especially in the case of class actions, an individual fraud may result in multiple filings. Finally, 
part of the more recent decline in securities filings may be attributable to a greater use of 
predispute arbitration agreements following the Supreme Court's decision in Shearson I Amer- 
ican Express, Inc. v. McMahon, 482 U.S. 220 (1987). 



115 

fiscal years concerning the number of lawsuits relating to the firm's audit practice, 
all damages awards or settlements and their amounts, the number of cases tried, 
the number of cases dismissed, and the number of instances in which the firm paid 
a disproportionate share of the damage as a result of joint and several liability 
rules.' 4 Although the Chief Accountant requested a response by the end of Novem- 
ber, the requested information was received only last Friday. 

Besides obtaining data regarding the volume and impact of private lawsuits, the 
Subcommittee should consider whether the amount of litigation could be reduced by 
measures other than those urged by the accounting profession. The profession often 
has expressed the view that investors expect too much from the audit function, and 
that auditors are blamed for failing to detect financial fraud even when they meet 
relevant professional standards. Nevertheless, given the unprecedented level of fi- 
nancial fraud witnessed over the past decade, particularly in the banking and sav- 
ings and loan sectors, the investing public and this Subcommittee have a legitimate 
right to ask why so many financial institutions failed shortly after receiving an un- 
qualified audit opinion. 

Before concluding that public expectations need to be lowered, or that liability 
standards need to be raised, it is important to consider ways to improve auditing 
standards and accounting principles. 1 * In this regard, it is commendable that policy 
statements recently issued by the profession recognize the need for more stringent 
professional standards and a greater focus on measures to prevent fraud. 16 

Finally, it is important to assess how much of the asserted liability crisis, particu- 
larly as it relates to accountants, is a function of State rather than Federal law. Ac- 
countants are liable under Section 10(b) and Rule 10(bX5) only if they act knowingly 
or recklessly, which courts generally describe as an extreme departure from the 
standard of ordinary care. By contrast, the law of many States permits accountants 
to be held liable on a showing of mere negligence in the performance of an audit 
or negligent misrepresentation in audit reports. Consistent with these differing li- 
ability standards, a survey by the "Big Six accounting firms found that Federal se- 
curities fraud claims accounted for only a fraction of all claims against accountants: 
Of the total cases pending against accountants in 1991, only 30 percent con- 
tained Rule 10(b)(5) claims. Of that 30 percent, less than 10 percent were exclu- 
sively 10(bX5) claims. The greatest liability exposure resides in the States. Reform 
of State liability laws affecting accountants is of critical importance to the future 
viability of the profession. 17 

Whether or not there is a sound policy basis for modifying liability standards 
under State law, the problems caused by those laws do not necessarily provide a 
compelling case for tampering with Federal standards. 18 

Proposals For Litigation Reform 

The remaining section of this testimony discusses various proposals that have 
been suggested in this area. The discussion does not purport to be exhaustive or to 
provide a definitive view on any of those proposals. Rather, it attempts to distin- 
guish proposals that would deter meritless securities claims without having a direct 
effect on valid claims from other proposals that would affect both types of claims. 



14 The request also asked the firms to provide information such as the size of each firm's audit 
staff, the amount of auditing revenues, the firm's capital and the cost of audit practice insur- 
ance. 

"The Commission's Chief Accountant has observed that, to a large extent, public accountants 
can control their own destiny. They can decide which clients to accept, and which financial pres- 
entations by their clients will receive unqualified opinions. They also can support the adoption 
of simpler, more objective accounting standards that would make it possible for them to obtain 
more objective and relevant evidence regarding their clients' compliance with those accounting 
standards, resulting in more reliable audit reports. In this way, both accountants and issuers 
would encounter less litigation regarding overstatements of assets, equity, and income. See Ad- 
dress by Walter P. Schuetze, Chief Accountant, Securities and Exchange Commission, before the 
American. Accounting Association, "Relevance and Credibility in Financial Accounting and Re- 
porting," at 9-11 (Aug. 12, 1992). 

16 The profession has also supported the "Financial Fraud Detection and Disclosure Act," H.R. 
574, introduced in the Senate by Senator Kerry as S.630, that would codify certain auditing 
standards designed to detect financial fraud, and require auditors to report suspected irregular- 
ities directly to the Commission under certain circumstances. See A1CPA Supports Fraud Detec- 
tion Bill, J. Acct., May 1993, at 15. 

17 Liability Crisis Paper, supra, note 1, at 6-7. 

18 Notably, the accounting profession has won several significant victories in the State courts 
over the past year. See Bily v. Arthur Young & Co., 3 Cal. 4th 370, 834 P.2d 745, 11 Cal. Rptr. 
2d 51 (1992); Security Pacific Business Credit, Inc. v. Peat Marwick Main & Co., 79 N.Y.2d 695, 
586 N.Y.S.2d 87, 597 N.E.2d 1080 (1992). See generally, Geoffrey F. Arnow, Accountants Lead 
the Latest Charge for Liability Reform, 7 Insights 17 (Feb. 1993). 



116 

1. Statute of Limitations 

In 1991, the Supreme Court held that private actions under Section 10(b) of the 
Exchange Act must be filed within one year after discovery of the alleged violation, 
and no more than three years after the violation occurred. 9 Because retroactive ap- 

glication of the new limitations period would have caused many significant cases to 
e dismissed, Congress enacted Section 27 A of the Exchange Act. This provision 
eliminated the retroactive application of the holding in Lampf, allowing litigants to 
seek reinstatement of cases that were timely when filed, but it did nothing to alter 
the effect of the Supreme Court's holding on a prospective basis. 

The Commission has stated previously that the existing limitations period is too 
short, and that Congress should enact legislation that would permit cases to be filed 
up to five years after a violation occurs, provided they are brought within two years 
after discovery of the violation. 20 Defrauded investors should not be deprived of a 
remedy simply because the perpetrator of a fraud manages to conceal its existence 
for more than three years. 21 Securities fraud is inherently complex, and even a dili- 
gent investor may not discover it until several years have passed. A significant 
number of the Commission's own fraud cases, in fact, are brought more than three 
years after the alleged violations. 22 

It should not be assumed that a three year statute of limitations is necessary to 
deter frivolous actions, or that extending the limitations period to five years some- 
how would encourage plaintiffs to file spurious claims. The most common complaint 
voiced by litigation reform proponents is that securities fraud actions are filed over- 
night, without any investigation, whenever an issuer announces reduced earnings 
or there is a precipitous drop in the market price for a security. To the extent that 
such cases are going to be filed, a three year statute of limitations is no more effec- 
tive in preventing them than a five year statute. The shorter limitations period does 
have the effect, however, of foreclosing relief for the victims of deliberately conceived 
and carefully hidden frauds. 

2. RICO Reform 

For a number of years, the Commission has supported legislative efforts to elimi- 
nate the overlap between private remedies under the Racketeer Influenced and Cor- 
rupt Organizations Act (RICO) and those available under the Federal securities 
laws. 23 It has taken this position because the securities laws generally provide effec- 
tive remedies for the victims of securities fraud. The civil liability provisions of 
RICO, however, permit plaintiffs to seek extraordinary remedies, such as treble 
damages and the recovery of costs and attorneys fees. Exposing issuers and other 
market participants to the threat of such extraordinary remedies has a coercive ef- 



1B Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 111 S. Ct. 2773 (1991). 

20 A Senate bill considered in the 102nd Congress (S. 3181) proposed the two year/five year 
limitations period endorsed by the Commission. A House bill (H.R.5828) proposed a three year/ 
five year period, with the shorter period commencing on the date that the plaintiff in the exer- 
cise of "reasonable diligence" could have discovered that a violation had occurred (as opposed 
to the date on which the plaintiff actually made that discovery). The Commission did not object 
to the time periods proposed in the House bill, but it did oppose the "reasonable diligence" re- 
quirement on the ground that such a standard would inevitably require a "trial within a trial" 
concerning when a violation was discoverable. 

21 The difficulty of ferreting out the facts underlying a financial fraud or accounting case is 
often overlooked in the debate over litigation reform. The Division of Enforcement can subpoena 
issuers and accountants to produce documents and provide explanations under oath. The Com- 
mission can also seek judicial enforcement of its subpoenas. Even with these resources, years 
of work may be required to unravel the questionable transactions and reporting. Investore have 
no means of compelling comparable access to information prior to filing an action, and can de- 
pend on no cooperation in sorting out the transactions from either issuers or accountants. Thus, 
investors are forced to allege wrongdoing based on sparse information and depend on discovery 
in court to flesh out their allegations. Moreover, investors must plead fraud with particularity, 
Fed. R. Civ. P. 9(b), which imposes a substantial burden in these types of cases. See, e.g., DiLeo 
v. Ernst & Young, 901 F.2d 624 (7th Cir. 1990), cert, denied, 498 U.S. 941 (1990). 

22 The limitations period specified in Lampf does not apply to Commission actions seeking a 
Federal court injunction or disgorgement, as these are governmental actions brought to vindi- 
cate a public right or interest. See Securities and Exchange Commission v. Rind, No. 91-66972, 
1993 WL 116449 (9th Cir. Apr. 19, 1993) (holding no statute of limitations applies to Commis- 
sion enforcement actions). With respect to Commission actions seeking civil money penalties 
under the Insider Trading Sanctions Act of 1984 (ITSA) or the Securities Enforcement Remedies 
and Penny Stock Reform Act of 1990, a five-year limitations period does apply. A five-year statr 
ute of limitations would put private actions for damages and Commission actions seeking civil 
penalties on a more equal footing. 

23 See, e.g., Testimony of Mary L. Schapiro, Commissioner, Securities and Exchange Commis- 
sion, "Concerning H.R. 1717, the RICO Amendments Act of 1991," Before the Subcommittee on 
Intellectual Property and Judiciary Administration of the House Judiciary Committee (Apr. 25, 
1991). 



117 

feet that tends to impede capital formation and place inappropriate financial bur- 
dens on commercial defendants. 

It should be noted that the Supreme Court's recent decision in Reves v. Ernst & 
Young 24 has narrowed substantially the exposure of accountants and other profes- 
sional advisers to RICO liability. In Reves, the Court held that, in order to be sub- 
ject to liability under the most frequently used section of RICO, a defendant must 
participate in the operation or management of the enterprise itself. An accounting 
firm that does nothing more than audit and issue a report on an issuer's financial 
statements generally will not meet this test. 

Although the Reves decision may diminish the exposure of professional advisers 
to liability under RICO, it is not likely to affect cases against issuers and broker- 
dealers. Accordingly, legislation to eliminate the application of RICO's civil liability 
provisions in private securities law actions continues to be appropriate. 

3. Class Action Reform 

During the 102nd Congress, the Commission expressed general support for certain 
measures designed to curb abuses in private securities cases brought as class ac- 
tions under the Federal Rules of Civil Procedure. These included measures that 
would prohibit the payment of additional compensation to a class representative, the 
payment of referral fees by class counsel, and service as class counsel by an attorney 
who has a beneficial interest in the securities that are the subject of the litigation. 
The Commission also supported a prohibition against the payment of attorneys fees 
from funds disgorged in a Commission action. 

While these measures, if enacted, would not adversely affect the prosecution of 
meritorious fraud claims, it is unclear whether they would significantly diminish the 
amount of baseless litigation. As several commentators have suggested, a class-ac- 
tion counsel tends to operate in an entrepreneurial capacity rather than as a fidu- 
ciary operating at the direction of a client. 25 It is likely that plaintiffs will be found, 
and that cases will continue to be filed, so long as the prospects of recovery are suf- 
ficient to warrant the cost of litigation. 

4. Fee-Shifting Proposals 

One other potential reform that has been suggested would provide that losing par- 
ties in private actions must, in some circumstances, reimburse a portion of the pre- 
vailing party's legal fees. Several of the express causes of action provided by the se- 
curities laws already contain provisions that permit fee shifting. In particular, Sec- 
tion 11 of the Securities Act provides that, as to actions brought under any provision 
of that Act, a party may be required to pay costs and reasonable attorneys fees "if 
the court believes the suit or the defense to have been without merit.'' The Sub- 
committee may wish to consider the extent to which amending Section 10(b) of the 
Exchange Act to include a similar fee-shifting provision would deter frivolous claims 
without having a significant chilling effect on meritorious actions. 

Rule 11 of the Federal Rules of Civil Procedure currently provides a mechanism 
for limited fee shifting in abusive and meritless cases. The Rule requires an attor- 
ney to certify that each pleading, motiofy or other paper filed in Federal court is 
"well grounded in fact and is warranted by existing law or a good faith argument 
for the extension, modification, or reversal of existing law." Filings may not be made 
for any "improper purpose, such as to cause unnecessary delay or needless increase 
in the cost of litigation." Should a court determine that a filing was made in con- 
travention of Rule 11, it "shall impose" upon the attorney, the represented party, 
or both, "an appropriate sanction, which may include an order to pay to the other 
party or parties the amount of reasonable expenses incurred because of the [filing], 
including a reasonable attorney's fee." 26 

According to a study of Rule 11 practice by the Federal Judicial Center (FJC), 
Rule 11 issues were raised or could be expected to be raised in 2 percent to 3 per- 



34 61 U.S.L.W. 4207 (U.S. Mar. 3 1993). 

28 See, e.g., John C. Coffee, Jr., Understanding the Plaintiffs Attorney: The Implications of Eco- 
nomic Theory for Private Enforcement of Law through Class and Derivative Actions, 86 Colum. 
L. Rev. 669, 683-84 (1986). 

36 Recently, the Supreme Court adopted significant substantive amendments to Rule 11. 
Under the Rules Enabling Act, these changes are to take effect on December 1, 1993, unless 
Congress intervenes to halt or modify the amendments. If the changes take effect, Rule 11 sanc- 
tions would be discretionary rather than mandatory, and parties would have a safe-harbor of 
2 1 days following notice of an alleged violation to withdraw the offending filing before a request 
for sanctions could be filed. 



118 

cent of Federal cases. 27 A survey of Federal district court judges conducted by the 
FJC, reflects that most judges Tbelieve that groundless litigation presents only a 
small problem on their dockets. 28 More than 80 percent of Federal judges also be- 
lieve that meritless litigation is controlled most effectively by prompt rulings on mo- 
tions to dismiss or motions for summary judgment. 29 

Any fee-shifting provision that is added to the Exchange Act should be limited in 
application to claims and defenses that are held by a court to be without merit. If 
not so limited, a fee-shifting provision would inevitably deter defrauded investors 
with meritorious claims from seeking compensation for their damages. In class-ac- 
tion litigation in particular, individual plaintiffs frequently have only a nominal 
stake in the action s outcome. Such plaintiffs could not afford to risk liability for de- 
fendant's legal fees given their small interest in the potential recovery. 

5. Proportionate Liability and Contribution 

Under current law, defendants in a securities fraud action are jointly and sever- 
ally liable, which means that each defendant is responsible for the entire amount 
of damages if the other defendants are unable to pay their share. There are propos- 
als to replace joint and several liability with a rule of proportionate liability, under 
which the judge or a jury would specify what percentage of damages each defendant 
is responsible for paying. The proponents of proportionate liability argue that the 
current system is inequitable because it forces parties with relatively little culpabil- 
ity to bear more than their share of the damages. An accounting firm that fails to 
detect a fraud, for example, potentially can be responsible for all of the damages 
if the issuer that perpetrated the fraud is insolvent. The proponents also argue that 
joint and several liability provides plaintiffs with an incentive to join as many "deep 
pocket" defendants as possible, ana encourages defendants to settle weak claims in 
order to avoid disproportionate liability. 30 

Although joint and several liability may cause accountants, attorneys, and other 
professional advisers to bear more than their proportional share of liability, it is im- 
portant to recognize that the current system is itself based on equitable principles 
that operate to protect innocent investors. Simply stated, as between innocent inves- 
tors who have been defrauded and professional advisers who have access to informa- 
tion within the company and have knowingly or recklessly assisted the fraud by fail- 
ing to meet professional standards, the risk of financial loss under the current sys- 
tem falls on the latter. In other words, our system does not deny defrauded investor 
an opportunity to receive full compensation simply because some defendants are 
more culpable than others. 

If the principle of joint and several liability is abandoned in favor of proportionate 
liability, the irony would be that investors would feel the greatest impact in pre- 
cisely those cases involving the most meritorious claims. Where an issuer enters 
bankruptcy after a fraud is exposed, for example, investors usually suffer something 
close to a total loss on their investment. A rule of proportionate liability would make 
it impossible for them to obtain full compensation for those losses, even if they liti- 

fate and prevail at trial. Thus, unwitting investors who find themselves taken in 
y a sham company might be told that they could recover no more than a few cents 
on the dollar, even if they established that accountants, attorneys, underwriters, 
and others had knowingly or recklessly assisted the fraud. 

Because proportionate liability legislation would often foreclose the possibility of 
complete recovery even in meritorious cases, legislation of this type might well affect 
investor confidence. As a result, some investors might decide not to participate in 
certain segments of the markets. Unless a compelling case for Federal legislation 
is established, the Commission believes it would be more appropriate to focus on 
measures more directly targeted at meritless litigation before considering any 
changes in the Federal scheme of liability. This is especially true given that, as the 
accounting profession acknowledges, most claims against accountants are brought 
under State law. 31 



27 FJC Directions, No 2., Nov. 1991, at 3. See generally Elizabeth C. Wiggins, Thomas E. 
Willging & Donna Stienstra, Rule 11: Final Report to the Advisory Committee on Civil Rules 
of the Judicial Conference of the United States (Federal Judicial Center 1991). 

28 FJC Directions, No 2., Nov. 1991, at 4. 

29 Id. at 31. 

30 See Liability Crisis Paper, supra note 1, at 2, which states that the average claim subjecting 
an accounting firm to joint and several liability was $85 million, but the average settlement of 
those claims was $2.7 million. 

31 Many States are experimenting with various revisions to their joint and several liability 
provisions in order to curtail possible abuses while protecting investors and others with meri- 
torious claims. Over two-thirds of the States have modified the common law tort principle of 
joint and several liability for claims based on negligence. These States have adopted a variety 



119 

As a less problematic alternative to proportionate liability legislation, the Sub- 
committee may wish to focus on issues related to the equitable doctrine of contribu- 
tion. Under this doctrine, which is closely related to the concept of proportionate li- 
ability, a defendant against whom judgment has been rendered may seek reimburse- 
ment from other persons who are jointly liable for payments made in excess of the 
defendant's share of the liability. Earlier this month, the Supreme Court held that 
a right of contribution is available in private actions under Section 10(b) and Rule 
10(bX5). a result urged by the Commission in an amicus curiae brief filed with the 
Court.** The Court has not resolved, however, a conflict among the circuits concern- 
ing how contribution should operate, particularly where there is a partial settlement 
of a multiparty action. For example, if one of several defendants settles a $10 mil- 
lion action for $1 million and a jury in the continuing litigation subsequently allo- 
cates 30 percent of the responsibility to the defendant who has already settled, 
should recovery against the remaining defendants be capped at $9 million ($10 mil- 
lion less the $1 million paid by the settling defendant) or $7 million (their propor- 
tionate share as determined by the Jury)? 33 

The Commission's brief in Mustek Peeler expressly did not take a position on 
which approach should be followed, and valid arguments can be made on either side. 
In the previous hypothetical, while plaintiffs (or their attorneys) argue that a rule 
limiting recovery against the non-settling defendants to $7 million would discourage 
plaintiffs from settling and also reduce deterrence, defendants argue that they 
should not be saddled with more than a proportionate share of liability simply be- 
cause the plaintiff settles part of the case too cheaply. 

Legislation in the area of contribution would be useful because, like the deter- 
mination of an appropriate statute of limitations, it involves striking the right bal- 
ance among competing policy concerns. Legislation in this area also would eliminate 
the current uncertainty regarding the manner in which contribution rights should 
be implemented. At the same time, because such legislation would not limit the abil- 
ity of investors to be fully compensated for their losses, it would not be as controver- 
sial as other proposals that would have that effect. 

6. Limitations on Aiding and Abetting Liability 

In many private securities fraud actions, parties other than the issuer are charged 
with aiding and abetting liability under Section 10(b) and Rule 10(bX5). 34 Although 
the precise formulation of the test for aiding and abetting liability varies somewhat 
from circuit to circuit, a plaintiff generally must prove: (1) the existence of a pri- 
mary violation by another; (2) scienter on the part of the alleged aider and abettor; 
and (3) substantial assistance by the alleged aider and abettor in achieving the pri- 
mary violation 35 

Most of the litigation in this area has involved the second element of the test. 
Thus far, all of the Federal Courts of Appeals that have addressed the issue have 
held that recklessness is sufficient to establish primary liability. These courts also 
have held that recklessness is sufficient for aiding and abetting liability in at least 
some circumstances. It is important to note, however, that the Supreme Court re- 
cently granted certiorari in a case involving the question whether recklessness, in 
contrast to actual knowledge, is sufficient to satisfy the scienter element of aiding 
and abetting liability. 36 



of modifications to the joint and several liability principle (e.g., proportionate liability once the 
plaintiff has collected 50 percent of total damages; proportionate liability if the defendant's rel- 
ative fault is less than a stated threshold- a cap on liability based on a multiples of relative 
fault if relative fault is less than a stated threshold). Only eleven have abolished it for substan- 
tial classes of case (e.g., negligence cases), and just two have greatly curtailed its availability. 
^Musick, Peeler & Garrett v. Employers Insurance of Wausau, 61 U.S.L.W. 4620 (U.S. June 
1, 1993). 

33 Compare Franklin v. Kaypro Corp., 884 F.2d 1222 (9th Cir. 1989), cert, denied, 498 U.S. 
890 (1990) with Singer v. Olympia Brewing Co., 878 F.2d 596 (2d Cir. 1989), cert, denied, 493 
U.S. 1024 (1990). 

34 Parties other than the issuer also may be subject to liability for primary violators of Rule 
10(bX5). On example of such a case is Griffin v. Arthur Young & Co., [1989 Transfer Binder] 
Fed. Sec. L. Rep. (CCH) % 94 543 (N.D. Cal. 1989) at 93,474 ("an accountant may be liable for 
a direct violation of Rule 10(b)(5) if its participation in the alleged misrepresentations) is direct 
and if it knows or is reckless in not knowing that the facts reported in the prospectus materially 
misrepresent the condition of the issuer."). 

38 See generally, Brief For the United States As Amicus Curiae at 10, Central Bank v. First 
Interstate Bank, cert granted, 61 U.S.L.W. 3403 (U.S. June 7, 1993) (No. 92-854). 

36 Central Bank v. First Interstate Bank, cert, granted, 61 U.S.L.W. 3403 (U.S. June 7, 1993) 
(No. 92-854). The Court also asked the parties to brief the threshold question whether there 
is an implied private right of action for aiding and abetting violations of Section 10(b) and Rule 

Continued 



120 

The Commission consistently has argued that recklessness, which generally is de- 
scribed as an extreme departure from the standards of ordinary care, is the appro- 
Kriate standard for both aiding and abetting and primary violations of Rule 10(bX5). 
[oreover, the fair and efficient operation of our securities markets depends upon 
the diligence of attorneys, accountants, underwriters and other participants. If such 
participants were exposed to liability only where the plaintiff could establish their 
actual Knowledge of fraud, as opposed to an "extreme departure from the standard 
of ordinary care," the deterrent effect of private actions would be greatly reduced. 
For these reasons, the Subcommittee should be wary of proposals that would limit 
the extent of aiding and abetting liability. One proposal, for example, would provide 
that liability for aiding and abetting is available only where a defendant acts with 
deliberate intent to deceive, manipulate, or defraud for his own direct "pecuniary 
benefit," which is defined to exclude ordinary compensation for services provided. 
This essentially would mean that accountants and attorneys would be immune from 

{>rivate liability under Section 10(b) and Rule 10(bX5) unless the plaintiff estab- 
ished that these professionals joined a conspiracy to defraud investors in return for 
a bribe. In short, no matter how egregiously accountants and attorneys departed 
from professional standards, they would not be deemed to have culpably assisted the 
fraud. Such a test would virtually eliminate aiding and abetting liability by confin- 
ing it to the types of cases for which criminal sanctions are most appropriate. 37 

Conclusion 

Legislative reform measures that have the potential to deter meritless private se- 
curities fraud cases deserve serious consideration. It is important, however, to exam- 
ine carefully the nature and scope of the alleged problem, and to weigh the con- 
sequences that each reform proposal might have on the existing financial reporting 
and disclosure system. Before resorting to changes in the standards for liability, or 
other measures that would affect meritorious actions as well as the baseless ones, 
it would be appropriate to determine the effectiveness of measures more directly tar- 
geted at meritless litigation. As always, the Commission and its staff will be pleased 
to assist the Subcommittee in this endeavor. 



10(bX5). Although every court of appeals to address this question has held that such an action 
for aiding and abetting liability is available, the Supreme Court expressly reserved this question 
in prior cases. See Herman & MacLean v. Huddleston, 459 IXS. 375, 379 n.5 (1983); Ernst & 
Ernst v. Hochfelder, 425 U.S. 185,192 n.7 (1976). A holding by the Court eliminating the avail- 
ability of private right of action for aiding and abetting violations would eliminate the primary 
means for compensating defrauded investors. 

37 The Commission rarely alleges that an accountant or an attorney intentionally furthered 
a fraud in return for a bribe. One example of such a case is In the Matter of Jose L. Gomez, 
CPA, Admin. Pro. No. 3-6547, Exchange Act Release No. 22293; AAER No. 68 (Aug. 6, 1985) 
(involving E.S.M. Group, Inc., E.S.M. Government Securities, Inc., and E.S.M. Financial Group, 
Inc.). 



121 



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122 

STATEMENT OF MARK J. GRIFFIN 
Director, Division of Securities, Utah Department of Commerce 

on behalf of the 
North American Securities Administrators Association 

Mr. Chairman and Members of the Subcommittee: My name is Mark Griffin. I am 
Director of the Utah Department of Commerce's Division of Securities and a mem- 
ber of the board of directors of the North American Securities Administrators Asso- 
ciation (NASAA). In the U.S., NASAA is the national voice of the 50 state securities 
agencies responsible for investor protection and the efficient functioning of the cap- 
ital markets at the grassroots level. On behalf of NASAA, I appreciate the oppor- 
tunity to appear before you today to discuss the important issues that have been 
raised in connection with private litigation under the Federal securities laws. 

Overview and Executive Summary 

Mr. Chairman and Members of the Subcommittee, it was less than two years ago 
that I appeared before the House Telecommunications and Finance Subcommittee 
to express the support of NASAA and its members for legislation which, in the wake 
of the Supreme Court's unfortunate decision in Lampf" would have put in place a 
fair and reasonable statute of limitations for securities fraud cases and reversed the 
retroactive application of the Court's holding. We were pleased to work at that time 
with Senator Bryan and other Members of this Subcommittee to pass legislation 
modifying the result of the Lampf decision, at least with respect to its retroactive 
application. 

Despite the diligent pursuit by many Members of Congress, including Members 
of this Subcommittee, to pass remedial legislation to restore and protect investor 
rights by modifying the prospective application of the shortened statute of limita- 
tions under Lampf some special interests seeking to immunize themselves from le- 
gitimate lawsuits have stymied such efforts. This has been accomplished by holding 
hostage the rather straightforward proposal to lengthen the statute of limitations 
to demands that it be linked to a whole host of unrelated and contentious litigation 
"reform" issues. Regrettably, these special interests have prevailed and defrauded 
investors today are left with severely restricted means of redress. 

We also would point out that the Lampf decision is only the latest in an unfortu- 
nate chain of U.S. Supreme Court decisions that have worked to systematically de- 
prive investors of their rights and remedies under securities laws by restricting 
their access to the Federal court system. This trend may be traced back through 
such cases as the 1987 decision in Shearson I American Express, Inc. v. McMahon 2 
and the 1989 decision in Rodriguez v. Shearson /American Express, Inc., 3 both of 
which reversed longstanding interpretations prohibiting the use of mandatory 
predispute arbitration clauses to deprive investors of access to the courts in cases 
arising under the 1933 and 1934 securities laws. NASAA believes that this judicial 
trend is contrary to the intent of Congress and in direct opposition to the best inter- 
ests of securities investors and the capital markets. 

Mr. Chairman and Members of the Subcommittee, where risk is an ever-present 
and vital factor in the investment world, fraud most definitely is not deserving of 
equal recognition as an unavoidable fact of life for investors. Curbs on private ac- 
tions brought by victimized small investors — as a result of either unrealistically 
short statutes of limitation or procedural restrictions — sends the devastating mes- 
sage that fraud no longer will be discouraged and penalized as it has been in the 
f>ast. Such a message could not come at a worse time and could well erode con- 
idence in the capital markets, reduce investment, and increase the cost of raising 
capital for U.S. businesses. 

Although the vast majority of those who work in the financial services industries 
are honest, hard-working individuals who take seriously their responsibilities as 



1 lll S. Ct. 2773 (1991). In this decision, a divided Supreme Court held that any private civil 
litigation instituted pursuant to Section 10(d) of the Securities Exchange Act of 1934 and Rule 
10(bX5) thereunder must be initiated within one year after the discovery of the facts constituting 
the violation and within three years after such violation has occurred. Prior to this ruling, and 
because no express statute of limitations existed for a Federal cause of action (as is true with 
implied rights), the courts "borrowed" or "absorbed" the local time limitation from the most anal- 
ogous state law. In rejecting that practice, the Court in Lampf applied the dramatically shorter 
one-and-three-year alternative of the express causes of action contained in the Federal securities 
laws adopted by Congress more than 50 years ago. 

2 482 U.S. 220. 

3 490 U.S. 477. 



123 

stewards of the public trust, the damage inflicted by those who are prepared to de- 
fraud the market can be tremendous. The excesses of the 1980's and early 1990's 
in the financial services arena have left investors with a deep — and all too well jus- 
tified — sense of concern. During the last decade, we witnessed financial frauds and 
scandals of historic proportions: The Salomon Brothers fraud in the government se- 
curities marketplace; Steven Wymer; BCCI and BNL; Charles Keating and Lincoln 
Savings: taxpayer bailouts for the saving's and loan debacle; the FBI sting operation 
at the Chicago commodities markets; and the so-called "Den of Thieves" ring of junk 
bond king Michael Milken, Ivan Boesky, Dennis Levine and Marty Siegel. And, 
every day small investors are victimized in less notorious — but equally devastat- 
ing — cases of fraud and abuse. 

It is against this backdrop that the broader and more complex issues raised by 
proponents of litigation "reform" must be considered. Mr. Chairman, your outline of 
discussion points for this hearing zeroed in on what is perhaps the core issue of the 
current debate: Is it possible to aiscourage frivolous litigation and still preserve rem- 
edies for legitimate claims? NASAA would agree with those who answer "yes" to this 
question. It is possible to discourage frivolous litigation and still preserve remedies 
for legitimate claims. Where we may disagree is on the appropriate approach for 
achieving this objective. La fact, it is NASAA's view that the courts currently have 
the tools necessary to deter frivolous or baseless suits without sacrificing important 
investor rights. The Federal Rules of Civil Procedure contain ample legal safeguards 
for the prevention and suppression of unwarranted or abusive securities suits. 
Emerging anecdotal evidence suggests that these rules, and in particular Rule 11, 
now are being invoked on a more frequent basis. There may be some value in a sys- 
tematic and comprehensive Congressional inquiry into the workings of these Rules 
of Civil Procedure. (If such a probe were to take place, NASAA respectfully would 
recommend that representatives of the judiciary be involved in the process so that 
a clear understanding of how the courts employ these rules may emerge.) 

Mr. Chairman and Members of the Subcommittee, NASAA is not in favor of en- 
couraging baseless and frivolous litigation. However, in a rush to respond to the 
pleas of the self-interested parties who are seeking to shield themselves from legiti- 
mate lawsuits, let us not lose sight of the primary mission of our securities laws — 
investor protection. The prescriptions we have been offered (in the form of various 
legislative proposals) to cure the perceived ills of the litigation process — including, 
changes in how liability is determined, shifting of attorneys' fees and costs, new 
definitions for the burden of proof, and changes in the rules governing class-action 
proceedings — may unintentionally give free rein to financial swindlers and other 
sharp operators. While such changes in the rules for bringing private actions under 
the securities laws may have the effect of eliminating a handful of dubious securi- 
ties fraud lawsuits, it will eke out this minuscule benefit only by inflicting a massive 
harm — an indiscriminate curb on access to the courts for all victims of financial 
swindles. NASAA fails to see the economic plus in unleashing future "entre- 
preneurs" of the Milken, Boesky or Wymer ilk from the fear of private actions 
brought by their victims. 

Fair access to redress grievances before an impartial tribunal lies at the heart of 
the American political and constitutional fabric. Our Federal and state constitu- 
tions, laws and court decisions place great emphasis on an individual's prerogatives 
and ability to seek justice in the courts. Today, that system is under attack. There 
is a sense that our legal system has gone haywire and that our economy is sagging 
under the weight of a litigation explosion." Proponents of securities litigation "re- 
form" have seized upon this popular notion that civil litigation in the United States 
is both expensive and excessive in order to advance their own agenda of further nar- 
rowing the rights of investors. 

If a probe into the true facts surrounding civil litigation in this country is war- 
ranted, should not the entire system go under the microscope? What public policy 
purpose is served by singling out defrauded investors for experimentation with new 
rules and procedures, such as "loser pays?" Given that securities litigation ac- 
counted for less than one percent of all cases filed in Federal courts in fiscal 1991, 4 
we do not see how dramatically limiting access to the courts for defrauded investors 
will result in any significant decrease in the overall civil litigation caseload. Fur- 
ther, NASAA questions why it is, when there has been a deliberate movement in 
the direction of making more uniform the procedural rules used by the Federal 
courts in civil cases, we now would fragment those rules for such a tiny percentage 
of all civil litigants. For these reasons, it is NASAA's view that any examination into 



4 Statement of Richard C. Breeden, Chairman, Securities and Exchange Commission, before 
the Subcommittee on Telecommunications and Finance, Committee on Energy and Commerce, 
U.S. House of Representatives, November 21, 1991, p. 15. 



124 

the current level of litigation in the United States must be comprehensive in nature 
and look at all types of litigation, not just one segment of all cases. Certainly, any 
such review would benefit greatly from the input of the judges who deal daily with 
civil litigation and may have views on how best to deter meritless lawsuits and 
abuses by lawyers. NASAA would welcome the opportunity to work with Members 
of this Subcommittee, your staffs and any other interested parties if such an effort 
is undertaken. 

The Role of Private Actions in Securities Law Enforcement 

The fundamental purpose of the Securities Act of 1933 and the Securities Ex- 
change Act of 1934 is to ensure full disclosure to investors and to punish those who 
violate the law. Within this framework, Section 10(b) of the Exchange Act was de- 
signed as a "catchall" anti-fraud provision to enable the Securities and Exchange 
Commission (SEC) to handle novel and unforeseen types of securities fraud. In- 
tended as a comprehensive anti-fraud provision operating even when more specific 
laws have no application, Section 10(b) makes it unlawful to employ in connection 
with the purchase or sale of any security "any manipulative or deceptive device or 
contrivance" 5 in violation of the Commission's rules. 

The courts implied a private right of action under Section 10(b) to encourage pri- 
vate enforcement of this overarching anti-fraud provision of the Federal securities 
laws. In fact, it may be argued that Section 10(b) of the Exchange Act and 
Rule 10(b)(5) thereunder represent the core provisions of the Federal securi- 
ties laws that prohibit deliberate fraud against investors. As to the impor- 
tance of Section 10(b) and Rule 10(bX5) in fighting investment fraud, the SEC has 
stated: 

As the law has developed, Rule 10(bX5) is vastly more important in combating 
fraud than are the express remedies provided in the 1933 and 1934 Acts . . . Sec- 
tion 10(b) and Rule 10(bX5) have come to embrace adversity of claims which could 
not have been envisioned in 1934. 6 

In more general terms, private actions have become increasingly important as an 
enforcement tool in light of the dramatic growth of fraud and corruption in the Na- 
tion's capital markets and financial institutions. The number, size and scope of in- 
vestment frauds detected in just the last several years are both well documented 
and staggering. At the same time, prosecutorial ana regulatory resources remain se- 
verely limited, with little realistic hope of material improvement. In fact, officials 
at the SEC recently were quoted as saying that "complex investigations of Wall 
Street wrongdoing may take longer and some smaller ones may never begin because 
of budgetary constraints." 7 This admission came in the document outlining Presi- 
dent Clinton's fiscal year 1994 budget proposal, which would require eliminating 42 
positions from the Commission's staff of 2,677. The proposed staff cutbacks "may 
cause some investigations to take longer to complete. Cases most likely to be af- 
fected by these delays include those involving complex frauds, such as market ma- 
nipulation schemes, or cases raising difficult accounting and auditing issues," the 
Commission said in the budget estimate documents. 8 

Given the demands on our criminal justice system, it is unreasonable to expect 
that criminal prosecution in the white collar area will reach more than just a frac- 
tion of those who engage in fraudulent or abusive conduct. Such resource restric- 
tions at the state and Federal levels argue in favor of broader private remedies, not 
the opposite, as would be the case if certain of the so-called litigation "reform" meas- 
ures are put in place. As my colleague from Missouri, John Perkins, testified before 
this body two years ago, no one — save those who commit the fraud in the first 
place — benefits from a wholesale assault on private rights of action. Tragically, the 
real price is paid by the small investor victims of fraud, not the increasingly clever 
and resourceful purveyors of the same. 

In short, private actions under the Federal securities laws are essential to deter 
prospective criminals, compensate the victims of fraud, and maintain public con- 
fidence in the marketplace. Accordingly, private securities litigation is critical to an 
effective enforcement program and is necessary to maintain investor confidence in 
the integrity, fairness and efficiency of our securities markets. 



8 15 U.S.C. Section 78j. 

"Brief of the Securities and Exchange Commission as Amicus Curiae at p. 23, Lampf v. 
Gilbertson, 90-333 (June 20, 1991). 

7 John Doyle, "SEC Staffing Cuts May Limit Investigations," Associated Press (Executive news 
service). 

•Doyle. 



125 

Recommendation: Lengthen the Statute of Limitations 

As noted earlier, in the 1991 Lampf decision, the Supreme Court adopted a uni- 
form limitations period for private actions under Section 10(b) of the Exchange Act 
and Rule 10(bXo) thereunder. The limitations period requires investors to bring 
such actions within one year of discovery of the facts constituting the fraud, but not 
later than three years after the fraud occurs. As a practical matter, this unduly 
short leash for securities fraud private actions eviscerates the rights of investors to 
seek recovery from those who participate in knowing and deliberate fraudulent ac- 
tivity. As a result, NASAA respectfully recommends that Congress modify the 
result in Lampf by adopting a longer statute of limitations for implied pri- 
vate actions under the Securities Exchange Act of 1934. The guiding principle here 
should be to adopt a statute of limitations that ensures that fraud victims have a reasonable opportunity 
to have their case heard in court. Further, NASAA supports a statute of limitations tied 
to the ACTUAL discovery of fraud rather than to the point in time when a 
plaintiff "SHOULD HAVE" discovered the fraud. Specific comments follow. 

The Self-Concealing Nature of Fraud 

It is our experience that victims of investment fraud often have no way of know- 
ing, nor reason to suspect for what may be many years, the truth about the mis- 
handling or abuse of their investments. Even once a suspicion of wrongdoing does 
arise, bringing out sufficient facts to merit filing a lawsuit may take additional and 
substantial periods of time. Most investors do not enter into a financial relationship 
with the expectation that they will be defrauded, particularly when the stockbroker 
or other financial professional with whom they are doing business has a fiduciary 
obligation of full disclosure. If these investors later receive financial statements and 
other official documents showing assets or growth earnings, they will be even less 
likely to suspect that they are being defrauded. 

The increasing complexity of the securities markets facilitates the act of conceal- 
ment that is inherent in most securities fraud cases. As a result, more and more 
investment vehicles are tailor-made to outlast the three-year period of repose re- 
cmired under the Court's Lampf ruling. For example, Ponzi schemes can maintain 
the illusion of a profit-making enterprise for years, as money from new investors 
is used to pay oft existing investors. It may be many years before such a scheme 
collapses under its own weight. 

When sentencing financier Michael Milken, U.S. District Judge Kimba Wood un- 
derscored the ease with which securities fraud may be concealed and the damage 
inflicted by such behavior on both the capital markets and investors: 

[there is] a legitimate public concern . . . that our financial markets in which 
so many people who are not rich invest their savings be free of secret manipula- 
tion. . . . [YJou may have committed only subtle crimes not because you were not 
disposed to any criminal behavior but because you were willing to commit only 
crimes that were unlikely to be detected. We see often in this court individuals 
who would be unwilling to rob a bank, but who readily cash Social Security checks 
that are not theirs when checks come to them in the mail because they are not 
likely to be caught doing so. . . . You also committed crimes that are hard to de- 
tect, and crimes that are hard to detect warrant greater punishment in order to 
be effective in deterring others from committing them. 9 

Consider also the fact that some types of investment instruments involve an ex- 

Eected life which extends well beyond the three-year cut-off period established by 
ampf. For example, limited partnership investments — in which investors have 
poured more than $150 billion since 1980 — often run for as many as seven to 10 
years. Until very recently, customer account statements for limited partnerships — 
a primary means of detecting fraud or misconduct — reflected only the original pur- 
chase price of the partnership, not the current market value. Therefore, for the vast 
majority of limited partners, it was only upon the expiration of the partnership that 
an investor uncovered misconduct or wrongdoing. Under the standard articulated in 
Lampf, that investor would be precluded from seeking redress in the courts, for no 
reason other than the decision to purchase a long-term investment. Holders of zero 
coupon bonds will face similar difficulties in uncovering fraud in the short period 
of time allowed under Lampf. At the very time when U.S. policymakers are seeking 
to encourage long-term investing as a means of stimulating capital formation, 
NASAA would suggest that it is unwise to simultaneously send the signal that long- 
term investments are made at a significant risk to the buyer because of restrictions 
on avenues of redress should fraud occur. 



'Comments by U.S. District Judge Kimba Wood, as excerpted by the Vfashinaton Post, No- 
vember 23, 1990, p. B12. 



126 

Finally, fraud arising in connection with Section 10(b) may be delayed in surfac- 
ing because such claims often involve fraud in relation to unregistered and exempt 
securities, such as municipal bonds and venture capital deals. Thus, investors often 
have no access to any organized and regulated method of ongoing reporting and are 
provided information only at the whim of the promoter. 

Even when securities fraud is detected, it is the experience of state securities reg- 
ulators that many — if not most— cases involving investment fraud take more than 
one year from the onset of an inquiry— or "discovery" — to carry out the investigation 
and commence litigation. In fact, the SEC has acknowledged that the Commission, 
even with all of its investigative resources and statutory powers, including compul- 
sory investigative processes, does not complete its investigations, on average, in less 
than 2.26 years. 10 Therefore, the Lampf decision would have the effect of frustrating 
even the most organized and targeted investigations of fraud. 

An Appropriate Statute of Limitations 

A review of state statutes of limitations is instructive in determining what may 
be an appropriate Federal standard for Section 10(b) claims. In at least nine 
states, the civil litigation statute of limitations for violation of anti-fraud 
sections of state securities laws runs only from the time of discovery " with 
no mmrimum period of repose. 11 

Thus, several states have recognized the self-concealing nature of securities fraud. 
Further, the trend at the state level has been to extend the statute of limitations 
for securities fraud actions. Consider just a few recent examples: Arkansas extended 
its statute from two years to five years from sale; Hawaii adopted a rule of "two 
years from discovery, but not more than seven years from sale"; Massachusetts went 
from two years from date of sale to four years after the discovery of the fraud; and 
Oregon extended its statute of limitations from "three years after the sale" to "two 
years from discovery or three years from sale, whichever is longer." u 

The most recent comment by NASAA on the question of appropriate statutes of 
limitations came in the context of the Association s critique of the proposed 1985 re- 
visions to the Uniform Securities Act. 14 In April 1991, the Association s Uniform Se- 
curities Act Committee recommended that the appropriate statute of limitations for 
private civil actions under the anti-fraud provisions of state securities laws should 
be the lesser of two years after the discovery of the violation or five years after the 
transaction constituting an alleged violation/ 5 

Based on experience, NASAA members know that many potential plaintiffs in 
cases involving fraudulent schemes are unaware of their cause of action or cannot 
move to proceed with a cause of action during the first year after a violation occurs. 
The limitation on actions imposed by Lampf will result in a great loss to investors 
simply because the perpetrators of a fraudulent scheme may be clever enough to 
mask detection for a period of time. Consider the case of fraudulent bond offerings, 
which by the long term nature of the investment easily can defeat the three year 
statute of repose. In addition, even relatively simple stock manipulation schemes 
may involve transactions that never could be unraveled and organized into intelligi- 
ble pleadings and proof in the one year time allotted after investors become sus- 
picious that something may be amiss and arguably are put on notice that they 
should have known of the violation. 

NASAA's position is that it is reasonable to impose a statute which limits 
actions to within three years after one knew of the facts constituting the vio- 
lation on which recovery is sought. However, if Congress feels that an outer 
limit is necessary to add certainly to commercial dealings, the Association 
would suggest a five year limitation period. 16 



10 Brief of the Securities and Exchange Commission as Amicus Curiae at p. 24, Lampf v. 
Gilbertson, 90-333 (June 20, 1991). 

11 By "discovery" in this context, we mean two years after actual discovery or two years after 
discovery should have been made in the exercise of reasonable diligence. 

12 The nine states are Alabama, Arizona, Indiana, Maine, Mississippi, Montana, New Jersey, 
Oklahoma, and Washington. 

"Brief For Respondents, at p. 20, Lampf v. Gilbertson, 90-333 (June 20, 1991). 

14 The securities laws of most states are based upon the Uniform Securities Act, which was 
approved in 1956 by the National Conference of Commissioners on Uniform State Law 
(NCCUSL). The states have periodically amended the Act since that time. The 1985 revision 
has been opposed by NASAA and has not been widely adopted by states. 

"NASAA Uniform Securities Act Committee Report, ANALYSIS AND CRITIQUE OF THE UNI- 
FORM Securities Act of 1985 (April 1991). 

ie The use of a five year period in the Insider Trading and Securities Fraud Enforcement Act 
of 1988 is indicative of a recent legislative trend to recognize that longer statutes are required 
for complex securities litigation. 



127 

NASAA's members are aware that balanced against the investor protection policy 
of anti-fraud statutes and the inherently difficult and time-consuming nature of dis- 
covering fraud is the basic rationale behind all statutes of limitation: To provide cer- 
tainty as to rights and liabilities. In securities transactions and financial reporting 
this certainty is undeniably important. Publicly-held companies registered under the 
Exchange Act must comply with auditing ana reporting obligations, and in prepar- 
ing financial reports auditors need some certainty as to when any contingent liabil- 
ity for a transaction may end. Accordingly, impositions of an outside time limit for 
filing suits regarding a transaction may be necessary to satisfy legitimate commer- 
cial needs for those who must conduct their business subject to the Exchange Act. 
However, NASAA would recommend that the courts be given the explicit discretion 
to invoke the doctrine of equitable tolling in those cases where the very nature of 
the investment instrument (such as is the case with limited partnerships) makes it 
virtually impossible for an investor to discover fraud within the statute of limita- 
tions. In such cases, the running of the limitations period would be suspended until 
the fraud has been discovered. 

Our final point here concerns the general issue of when it is that the statute of 
limitations kicks in — either when the violation actually was discovered or when the 
violation should have been discovered. NASAA supports a statute of limitations tied 
to the actual discovery of fraud rather than to the time when a plaintiff "should 
have" discovered the fraud. In this respect, NASAA is in agreement with former 
SEC Chairman Richard Breeden who said, 

A 'reasonable diligence' standard is unfair to fraud victims because almost every 
defendant can allege that a plaintiff 'should have' discovered a fraud earlier. 
Thus, this requirement would prompt a considerable amount of needless litigation 
to resolve subtle shadings of what an investor could or might have done. It would 
be ironic and unfortunate if a bill that is intended to reduce litigation included 
a provision that would significantly increase the cost of litigation in an unneces- 
sary manner. 17 

A "reasonable diligence" stand imputes to a plaintiff the knowledge that could 
have been learned about a fraud if all the facts at the plaintiffs disposal had been 
investigated with reasonable diligence. In financial markets, these signals may often 
be ambiguous. An absence of a duty of inquiry does not entitle investors to ignore 
clear evidence of fraud. 

Private Actions and Frivolous Suits 

Section 10(b) and Rule 10(bX5) have come under increasing attack as facilitating 
frivolous or baseless lawsuits against innocent market professionals. While there 
certainly may have been meritless or Questionable cases brought in the past under 
this rule, existing case law clearly spells out when recovery under Rule 10(bX5) is 
available. Plaintiffs seeking damages under Section 10(b) and Rule 10(bX5) must 
prove that: 

• The plaintiff was a purchaser or seller of securities; 

• The defendant engaged in a fraud, manipulation or deception; 

• The fraud, manipulation or deception was in connection with the purchase or sale 
of the securities; 

• The defendant acted with scienter (an intent to deceive or a reckless disregard 
for the truth or falsity of statement; 

• The defendant's misstatement or nondisclosure was material; 

• The plaintiff reasonably relied upon the defendant's misstatement or 
nondisclosure; 

• The plaintiff was damaged; and 

• The defendant's conduct caused the plaintiffs damages. 

It should go without saying that satisfying this burden of proof requires consider- 
able evidence of wrongdoing. Unlike most of the express private actions to which 
Congress originally appliea the one year/three year statute of limitations, Rule 
10(bX5) liability is based upon deliberate and intentional fraud and not merely neg- 
ligent violations. 

While the debate surrounding the allegations of an explosion in frivolous securi- 
ties lawsuits is far from settled, let us assume for a moment that financial services 



17 Letter from Securities and Exchange Commission Chairman Richard Breeden to Senator 
Terry Sanford, August 12, 1992. 

18 A recent article in The Economist observed that: "Ambulance chasers have no monopoly on 
frivolous litigation. Businesses are equally guilty. One top American M&A [mergers and acquisi- 

Con tinned 



128 

firms have in fact been unfairly targeted by unscrupulous plaintiffs' attorneys seek- 
ing to enrich themselves at the expense of these honest companies. What procedural 
tools are available to address such abuses? 

There is emerging evidence which suggests that the Federal Rules of Civil Proce- 
dure are playing an increasingly important role in weedingout frivolous or meritless 
securities lawsuits. In particular, Federal Rules of Civil Procedure 9 and 11 place 
a substantial burden on victims to plead their cases with particularity and to make 
a reasonable investigation before filing their cases. Rule 23 (governing class-action 
proceedings) and Rule 26 (discovery) also may play a role in deterring unwarranted 
suits. In addition, the Civil Justice Reform Act of 1990 may serve as the basis for 
even further streamlining of the litigation process. These issues are discussed in 
brief below. 
Rule 9. Federal Rule of Civil Procedure 9(b) requires that securities fraud claims 
be pleaded with particularity and that each defendant's role in the illegal fraud 
be set forth in detail. Under this rule, the matter would be dismissed unless a 
prima facie case of fraud was established against a defendant. Because this often 
is the first motion filed in a case, it can serve as a powerful tool in limiting litiga- 
tion costs. 

Rule 11. This rule permits a U.S. district court judge to impose sanctions, includ- 
ing requiring plaintiffs' lawyers to pay the defendants' legal fees, for any com- 
plaint filed without adequate investigation and factual basis. It is our understand- 
ing that millions of dollars in Rule 11 sanctions have been imposed since the rule 
was strengthened a few years ago. Revisions to Rule 11 recently approved by the 
Judicial Conference of the United States would require that a party be notified 
in writing that he or she may have violated Rule 11 Defore opposing counsel could 
move for sanctions. The party then could respond or forego the suit to avoid a pen- 
alty. Judges also would be free to impose any monetary or non-monetary penalty 
sufficient to deter violations. 
Judges have not been hesitant to use Rule 11 sanctions where deemed appro- 
priate, including cases involving plaintiff lawyers abuses, 19 unfounded plead- 
ings, 2 " and misstatements made to the court. 2f In 1989 alone, Rule 11 was in- 
voked some 6,500 times in Federal courts. 22 

A comprehensive review of Rule ll's applications and effects recently was con- 
ducted by the American Judicature Society. 23 To get a broad, national perspective, 
the surveyors chose to examine Rule 11 activity in three Federal judicial circuits: 
the Fifth, Seventh, and Ninth. These three circuits were chosen because they pro- 
vided both significant geographic diversity (south, midwest and west) and variability 
in the perceived incidence of Rule 11 motions and sanctions. A random sample of 
cases was drawn from the 1989-90 civil dockets and the lead attorney from each 
side was included in the sample. Among the findings of the survey: (1) the frequency 
of formal Rule 11 activity is significant but not necessarily large; (2) frivolous suits 
or claims was the most frequent response to the question asked about the basis for 
Rule 11 motions and sanctions; and (3) when asked, "What is the biggest impact, 
if any, of the sanctioning provisions of Rule 11 on your practice?," the most fre- 
quently cited impact was "more factual investigation. It would appear that Rule 11 



tions] lawyer says that a target company's first response to a hostile takeover should be to sue 
the bidder — whether or not it has done anything wrong. When employees of a high tech firm 
leave to start a new company, they often are hit with a trade secret suit before they have even 
opened their new offices. Businessmen do not call such litigation 'frivolous'; they call it 'strate- 

fic' Indeed, it is business litigation that is growing fastest. Corporate litigators, who are paid 
y the hour, have as much incentive as contingency fee lawyers to drag cases out." ( , "Order 

in the tort," The Economist, July 18, 1992, pp. 10-13.) 

19 Pennsylvania Judge Louis C. Bechtle recently ordered sanctions against three shareholders' 
lawyers. The judge chided the lawyers for allegedly drumming up litigation by enlisting share- 
holders to file lawsuits against companies facing adversity. In addition to dismissing two of the 
three lawsuits brought by the plaintiffs' attorneys, Judge Bechtle ordered the plaintiffs' lawyers 
to pay the defendant's legal fees and referred the case to the Pennsylvania state disciplinary 
body to see if additional punishment was warranted. For additional information, see, Jonathan 
Moses, Three Shareholder Lawyers Sanctioned," Wall Street Journal, February 5, 1993, p. B7. 

20 For example, in Brandt v. Schal Associates, Inc., the U.S. Court of Appeals for the Seventh 
Circuit imposed a $351,664.96 fine against attorneys and their clients who filed unfounded 
pleadings. 

21 For example, in Navarro-Ayala v. Nunez, the U.S. Court of Appeals for the First Circuit 
imposed a personal fine of $6,000 against the assistant secretary of mental health for Puerto 
Rico who made statements to the court that had no factual basis. 

22 David Frum, "Shoot the Hostages," Forbes, December 21, 1992, p. 138. 

23 See, Herbert Kritzer, Lawrence Marshall, and Frances Kahn Zemans, "Rule 11: moving be- 
yond the cosmic anecdote," Judicature, Volume 75, Number 5, February-March 1992, pp. 269- 
272. 



129 

has tremendous potential for deterring the frivolous cases of concern to this Sub- 
committee and others. 

Rule 23(a). This rule requires that plaintiffs who are seeking class certification 
demonstrate that: (1) the class is so numerous that joinder of all members is im- 
practicable; (2) questions of law or fact are common to the entire class; (3) the 
claims and defenses of plaintiffs are typical; and (4) plaintiffs will adequately pro- 
tect the interests of the class. 

Rule 26. Rule 26 of the Federal Rules of Civil Procedure deals with the issue of 
discovery. Currently under discussion, proposed revisions to the rule would at- 
tempt to reduce the costs and time consuming aspect of civil discovery by impos- 
ing on the parties to a suit a duty to disclose basic and detailed information with- 
out waiting for a formal discovery request. 

Civil Justice Reform Act (CJRA) Passed in 1990, the Nation's Federal district 
courts now are implementing the CJRA. Under this Act, each district court must 
draw up a plan where each civil case will be evaluated early on and assigned to 
fast, very fast or complex tracks. The plans are being crafted with guidance from 
local advisory panels of lawyers, judges, academics and other persons. Although 
congressional focus in CJRA was concentrated primarily in the areas of civil dis- 
covery and alternative dispute resolution, the procedural changes being effected 
by the district courts may cover broader areas of civil litigation. The first batch 
of plans involving 34 district courts was sent to Congress in June of last year. 
The remaining 60 districts must complete their plans by December of this year. 24 

General Comments on Proposals to "Reform" Securities Litigation 

Mr. Chairman and Members of the Subcommittee, NASAA respectfully urges you 
to reject the legislative initiatives now being promoted as litigation "reform" by the 
very same parties who brought us mandatory securities arbitration and dramati- 
cally scaled back statutes of limitation for securities fraud lawsuits. Although these 
proposals have been dressed up in "anti-lawyer" rhetoric, they more accurately may 
be seen as being anti-investor in nature. Just as the efforts to force arbitration on 
investors and to shorten the statute of limitations for securities fraud suits trampled 
on the rights of defrauded small investors, these new initiatives to hamstring the 
securities plaintiff bar would go even further to shrink the redress opportunities to 
investors and, in practical terms, would "immunize" the securities industry and 
other special interests from lawsuits. For these reasons, NASAA generally opposes 
the following proposals: 

Limitations on joint and several liability. The concept of proportionate liability 
has now been suggested for securities fraud actions, as has a new and untested 
standard of "knowing securities fraud" which would be required to be met in order 
to retain the current joint and several liability standard. Otherwise, even where 
the defendant was engaged in reckless or grossly negligent conduct, liability 
would be measured in terms of the nature ofthe conduct and the extent of the 
causal relationship between that conduct and the damage suffered by the plaintiff. 
To meet the definition of "knowing securities fraud" the defendant would have to 
make a material misrepresentation or omission with actual knowledge that the 
representation is false or that as a result of the omission, a material misrepresen- 
tation made is false and would have to know that other persons are likely to rely 
on the misrepresentation or omission. 

Fee shifting. Borrowing from the so-called "English Rule," it has been suggested 
that Federal courts be granted the authority to award attorneys fees and reason- 
able expenses to the prevailing party unless the court determines that the position 
of the losing party was substantially justified. The determination whether the po- 
sition of the losing party was substantially justified would be made on the basis 
of the record which is made in the civil action for which fees and other expenses 



34 For example, in 1991, the U.S. District Court for the Eastern District of Pennsylvania 
unanimously adopted the first plan under CJRA. The Plan includes self-executing discovery 
rules that require parties to disclose important information within 30 days after service of an 
answer. For most cases, the Court must set an early and firm trial date within one year of the 
filing of the complaint. For complex cases Involving a number of parties, claims, defenses, or 
need for extensive discovery, the trial date may be extended to 18 months from date of filing 
the complaint. The early trial date requirement recognizes that most civil cases settle in the 
face of a looming trial date and lawyers often expand their work to fill time available. The Plan 
also requires arbitration within four months from filing an answer for virtually all cases where 
damages Bought are less than $100,000. For cases not subject to arbitration, the Plan requires 
an early mediation conference with a court-approved mediator for the purpose of defining the 
issues and exploring settlement. For more information, see G. Bennett Picker, "Philadelphia 
Plan Designed to Cut Federal Court Costs," Corporate Legal Times, December 1992. 



130 

are sought. Allocation of the award and the size of the award lie in the judge's 
discretion. In addition, it has been suggested that awards of attorneys fees and 
expenses be provided to the prevailing party in an adjudication of any motion for 
an order compelling discovery or protective order unless the court finds that spe- 
cial circumstances make an award unjust. This proposal may very well have the 
effect of sparing off middle class Americans from Dringing bona fide securities 
fraud claims for fear of being liable, upon a judge's ruling, for ruinous litigation 
costs. 
Abusive practices. Lumped under this proposal is the introduction of several re- 
strictions on class-action securities fraud suits. 

♦ First, it would be required that the share of any final judgment or settlement 
be awarded equally to all plaintiffs, including the representative plaintiff. 

♦ Second, no attorney who directly or indirectly owns or otherwise has a bene- 
ficial interest in the securities that are the subject of litigation or an attorney 
affiliated with such attorney would be allowed to represent a plaintiff class-ac- 
tion case. 

♦ Third, no attorney would be permitted to represent a class action where he or 
she has paid or is obligated to pay a fee to a third party who assisted him or 
her in obtaining the representation of the party to the action. 

♦ Fourth, funds that have been disgorged could not be distributed as payment 
for attorney fees or expenses incurred Dy private parties seeking distribution of 
the disgorged funds and any judgment awarded against any person shall be di- 
minished by the amount of any disgorged funds. 

Burden of Proof. In any implied cause of action arising under the 1934 Act in 
which the plaintiff may recover money damages only if it proves that the defend- 
ant acted with scienter, the plaintiff would have to establish that element of his 
claim by clear and convincing evidence. 

Pleading requirement. Under this proposal, in those cases where proof of scienter 
is required for recovery of monetary damages, the plaintiff must allege in its com- 
plaint facts suggesting that the defendant acted with that state of mind. 
Aiding and Abetting. For recovery of monetary damages where proof of scienter is 
required, it would be required that for a defendant to be an aider and abetter, 
the plaintiff must prove that the defendant knew that another party had violated 
a provision of the 1934 Act and the defendant, acting with deliberate intent to 
deceive, manipulate or defraud for the defendant's own pecuniary benefit, pro- 
vided substantial assistance to the other party's violation. Direct pecuniary bene- 
fit would not include ordinary compensation for services provided. 
Mr. Chairman and Members of the Subcommittee, while NASAA urges you to re- 
ject these proposals, we nonetheless share your concern that frivolous lawsuits be 
dealt with swiftly and firmly. Toward that end, we would recommend a thorough 
examination of the application of the Federal Rules of Civil Procedure. If there is 
a concern that they are not being applied often or rigorously enough, let us find out 
why. NASAA believes that it be would unwise, in the name of "reform," to further 
restrict the ability of defrauded investors to be made whole. Rather, NASAA would 
recommend a deliberate, thorough and objective examination of the rules and proce- 
dures of civil litigation to see where improvements and further streamlining may 
be warranted. We would offer our support and assistance in any such effort. 

Finally, Mr. Chairman and Members of the Subcommittee, I want to thank you 
for the opportunity to appear before you today. I also want to take this opportunity 
to commend you and your staffs for your efforts to advance the rights and interests 
of small investors. We are hopeful that the limited partnership roll-up reform legis- 
lation soon will become a reality, and that improvements to the Federal scheme of 
investment advisor oversight soon will be put in place. We look forward to working 
with you and your staffs on these critically important issues affecting small inves- 
tors. 



TESTIMONY OF JOEL SELIGMAN 

My name is Joel Seligman. I am a professor of law at The University of Michigan 
Law School and coauthor with Professor Louis Loss of Harvard Law School of an 
11 volume treatise on Securities Regulation. 

I would like to offer five observations for your consideration. 

First: There is little objective data at this time that suggests there is a need for 
significant reform of the Federal securities laws, either to benefit plaintiffs or de- 
fendants. The SEC in its 1992 Annual Report at 52, for example, reported: 



131 

Despite general economic conditions, the total dollar amount of securities filed 
for registration with the SEC during 1992 reached a record of over $700 billion, 
a 40 percent increase from the approximately $500 billion registered last year. 
The number of issuers accessing the public markets for the first time soared, with 
initial public offering (D?0) filings of equity or debt reaching $66.5 billion, an in- 
crease of about 53 percent from the $43.6 billion filed in 1991. 
According to the New York Stock Exchange, in 1990 over 51 million United States 
citizens directly owned corporate stock, N.Y. Stock Exch., Fact Book 70 (1992), with 
tens of million more owning stock indirectly through institutional investors which 
in aggregate held over $2 trillion in equity securities in 1992. Id. at 28. 

Second: One reason that the United States has achieved its current success in 
capital formation and breadth of securities ownership is the Federal securities laws' 
mandatory disclosure system, as enforced by Government and private litigation. It 
is significant, I believe, that the United States both has the broadest stock owner- 
ship and the most demanding disclosure system. See 2 L. Loss & J. Seligman, Secu- 
rities Regulation 792-801 (1989 & 1992 Ann. Supp.). The mandatory disclosure sys- 
tem has performed a significant role in maintaining investor confidence in the secu- 
rities markets and deterring securities fraud. 1 id. 171-225. 

Third: Private litigation performs a significant role in enforcement of the manda- 
tory disclosure system. Former SEC Chairman David Ruder noted in 1989 that in 
recent years less than 10 percent of cases involving securities or commodities have 
been brought by the Government. Ruder, The Development of Legal Doctrine 
through Amicus Participation: The SEC Experience, 1989 Wis. L. Rev. 1167, 1168. 
T6 be sure, the private litigation system is not perfect. But I want to highlight 
that the judiciary has been effective in addressing perceived problems. In 1991, for 
example, the Supreme Court adopted an one year after discovery and three years 
after violation statute of limitation for Rule 10(bX5) litigation that typically short- 
ened the applicable limitations period. Lampf, Plevy, Lipkind, Prupis & Petigrow v. 
Gilbertson, 111 S. Ct. 2773 (1993). In the last few years lower Federal courts appear 
also to have increased the number of Federal securities law claims dismissed for 
failure to plead fraud with sufficient particularity, see 10 L. Loss & J. Seligman, 
Securities Regulation 4525-4530 (1993); increased their willingness to sanction 
plaintiffs' attorneys for frivolous litigation under §ll(e) of the Securities Act, Rule 
11 of the Federal Rules of Civil Procedure, and kindred standards, see id. at 4644- 
4654; and in certain circuits reduced the exposure of accountants and attorneys to 
aiding and abetting liability. See 9 id. at 4479-4488. 
A long articulated critique of corporate and securities private litigation is that the 

filaintiffs' attorneys, not the plaintiffs, largely benefit. I submit to you this critique 
ails adequately to take into account that the primary purpose of both Governmental 
and private securities litigation is the deterrence of securities fraud. 

Fourth: There is no secret that a major proponent of recent proposals to "reform" 
private securities litigation has been elements of the accounting industry. 

I think it is worth highlighting that some of the litigation Crisis" that they seek 
to correct can be attributed to fauures in auditing and accounting practices. Leaving 
private litigation for the moment aside, since 1970, for example, there have been 
over 120 Rule 2(e) proceedings brought against accountants. See 10 L. Loss & J. 
Seligman, Securities Regulation 4804^1806 n.62 1993); of the 60 §15(cX4) proceed- 
ings brought against issuers between 1975 and June 1985, 46 were said to have con- 
cerned accounting and financial disclosures. McLucas & Romanowich, SEC Enforce- 
ment Proceedings under Section 15(cX4) of the Securities Exchange Act of 1934, 41 
Bus. Law. 145, 152 (1985). Similar totals have begun to develop for accounting viola- 
tions of the Commission's cease and desist powers which were only adopted in 1990. 
10 L. Loss & J. Seligman, Securities Regulation 4911-4914 (1993). 

Fifth: Given this background certain recent proposals appear to be little more 
than the equivalent of special pleading by a profession which has recently often 
been successfully sued. Turning to the more significant of these proposals, adoption 
of the English rule for attorneys and related costs would, in effect, prevent most 
class-action plaintiffs from initiating litigation, including meritorious litigation. 
Similarly repeal of the joint and several habiUty concept potentially could signifi- 
cantly reduce the deterrent force of private securities litigation. 

At the same time, let me emphasize there are problems in securities litigation 
that justify thoughtful consideration. In my view the most significant has been the 
apparent substantial increase in discovery costs in recent years. I am skeptical that 
this is an area where it would be appropriate for different disclosure rules to apply 
to securities claims than for other forms of private litigation. Nonetheless my recent 
experience as a court-appointed disinterested person in a shareholder derivative ac- 
tion suggests to me that this may be the most promising area in which the trans- 
action costs of private securities litigation might be reduced without jeopardizing 



132 

the ability of plaintiffs to litigate meritorious claims. See Seligman, The Disin- 
terested Person: An Alternative Approach to Shareholder Derivative Litigation, 55 
Law & Contemp. Probs. 357 (1992). 



PREPARED STATEMENT OF PATRICIA REILLY 

I want to thank Chairman Dodd and the other Members of the Securities Sub- 
committee for giving me the opportunity to relate my experiences as a stockholder 
in some securities class-action lawsuits. 

I have been a shareholder, and part of the plaintiffs class of investors, in 2 dif- 
ferent securities class-action lawsuits. One was against Pace Membership Ware- 
house, its officers and directors, its investment bankers, and its accountant. The 
other was against Tucson Electric Power, its officers and directors, its attorneys, its 
investment bankers, and its accountants. 

It is my understanding that securities class-action lawsuits were created (1) to 
provide a means for investors to recover their losses which were caused by the fraud 
and misrepresentations of a company's officers and directors, and (2) to hold these 
officers and directors accountable by making them personally liable for the losses 
caused by their fraud and misrepresentations. 

As a result of my experience, I have come to realize that securities class-action 
lawsuits exist for the benefit of the stockholders' lawyers. The stockholders, the vic- 
tims of the fraud committed by a company's officers/directors, recover virtually none 
of their losses. In the vast majority of the cases, the stockholders recover less than 
$.10 on the dollar of their losses. Ninety-six percent of the securities class-action 
lawsuits settle. The cases normally settle for the amount of directors' and officers' 
liability insurance and nothing more. Usually the directors and officers who commit- 
ted the fraud do not pay a dime. Meanwhile the stockholders' lawyers make mil- 
lions. As a stockholder, I feel that the lawyers use the stockholders, preying on their 
misfortune, as a means to file a lawsuit that will inevitably settle in which the law- 
yers will reap millions in fees, while their clients will recover pennies on the dollar 
of their losses. 



133 

HOW THE SECURITIES CLASS ACTION LAWSUITS APPEAR TO ME 



WHAT IS SUPPOSED TO HAPPEN 

Offense 
FRAUD - MISREPRESENTATION 



$$$$$$ 

Victim < Offender 

STOCKHOLDER OFFICERS & DIRECTORS 

Compensated for Personally Liable 

Losses caused by for Losses caused to 

Officers' and Shareholders for 

Directors ' Fraud their Fraud 



WHAT ACTUALLY HAPPENS 



$$$$$$ 

LAWYERS < INSURANCE COMPANY 

Insurance premiums passed on 
to company's clients and/or 
stockholders 



STOCKHOLDER OFFICERS & DIRECTORS 

Usually receive Usually pay nothing 

6% of their losses 



134 

MY EXPERIENCE 

I. Pace Membership Warehouse 

I am, and have been for the past 12 years, a stockbroker with major, national bro- 
kerage firms. In addition, I am an arbitrator with the National Association of Secu- 
rities Dealers (NASD) and the American Arbitration Association. 

A little under 3 years ago, I received notice of a settlement offer and a request 
for legal fees in a securities class-action lawsuit against Pace Membership Ware- 
house (PACE), its officers and directors individually, its underwriters and its ac- 
countant. I received the notice because I was a stockholder during the class period, 
but I had a special interest in the case aside from being a stockholder. As a stock- 
broker, I had 42 accounts that owned the stock during the class period. 

Pace Membership Warehouse was one of those companies that sold brand name 
products at low prices in a warehouse style setting. My clients and I bought the 
stock because it was highly recommended by a number of Wall Street analysts who 
projected rapid earnings growth. Quarter after quarter, the management kept mak- 
ing statements that in the next quarter the company would have earnings. The 
earnings never came. From the time Pace went public to approximately IVi years 
later the stock continued to drop in value. Eventually, management was kicked out. 
New management came in, turned the company around, and the company was 
bought outby K-Mart. 

A securities class-action lawsuit was filed covering part of the time that the stock 
dropped in value. The lawsuit alleged fraud and misrepresentation by Pace's officers 
and directors as the basis for why the stock had dropped in value. 

There was a settlement offer reached in the case for $9,125,000. The settlement 
money was to come from insurance proceeds. The shareholders' lawyers were re- 
questing 40 percent of the settlement fund in legal fees. In addition to 40 percent, 
the shareholders' lawyers wanted $600,000 for out-of-pocket expenses. No where in 
the notice of the proposed settlement were the shareholders told what percent of 
their losses would he recovered in the settlement, only that the total settlement was 
$9,125,000. 

If the lawsuit was right — that there was fraud committed by the officers and di- 
rectors — then as investors, I felt that we had been duped by the company. Then, 
along came the lawyers who said they wanted to help the stockholders recover their 
losses, and they wanted $4,250,000 out of a $9,125,000 settlement. I thought it was 
outrageous. 

There was a date set for a hearing on the settlement offer and the requested legal 
fees. As a stockholder, I had the right to attend. I sent a letter to the Settlement 
Judge and copies to each of the law firms. I stated my objection to the legal fees 
and my intention to attend the hearing. I took a day off of work, without pay, and 
flew, at my own expense, to the settlement hearing in Denver. Although the stock- 
holders' lawyers had received notice of my opposition to the legal fees and my plan- 
ning to attend the hearing, they failed to provide me with copies of their hourly fees 
ana expenses. The Judge felt I should have an opportunity to review the lawyers' 
billable hours and out-of-pocket fees; however, because the court calendar was 
booked for that day, the matter was continued for a month. This meant another day 
off of work, and a second trip to Denver. 

By the way, I, like so many of the shareholders in these class-action suits, had 
a small number of shares. I had 200 shares. My investment in Pace was $3,167.51. 
My recognized loss for purposes of the claim was $1,751.51. Not much money. In 
fact, I was the type of person for whom these class-action lawsuits were created — 
the shareholder who had too little at stake to individually sue a company for fraud. 

The Court at the first hearing had also expressed some concern with the legal 
fees, but the Court recognized that it did not have the ability to investigate the ac- 
curacy of the legal fees. So the Court asked me if I would determine what the going 
hourly rate was in my locale for this type of work. The Court also authorized me 
to go over to the attorneys' office to go through their billings to verify their charges. 
In other words, because the system is set up so that the courts do not have the abil- 
ity to determine if the fees are excessive, it places the burden on someone like my- 
self, who ultimately recovered $250.31, to investigate the lawyers' request for 
$4,250,000 in legal fees. I am not a bookkeeper nor an accountant. 

The courts do not have the ability, and the shareholders are too small, and nor- 
mally do not have the capability, to monitor the lawyers and their legal fees. There 
are no checks and balances on the lawyers and their fees. It is a perfect opportunity 
for abuse by the shareholders' lawyers. 

Between the first and second hearing, "my" lawyers buried me with legal papers, 
cases, affidavits, etc. I spent 60 hours of my time on this issue of legal fees. I did 



135 

discover, though, some interesting things about their request for fees of $4,250,000. 
(1) The stockholders had 5 law firms with 35 attorneys representing them on this 
case. (2) The shareholders lawyers spent 8,935 hours on this case. To make a com- 
parison, if someone worked a 40 hour a week job, 50 weeks a year, this would be 
over 4 years of full employment. (3) There was over $95,000 spent on xeroxing. (4) 
The highest paid attorney for the shareholders was William Lerach at $450 an hour. 
(5) The total nourly fees for the shareholders' attorneys were: $2,090,438. 

As the judge directed me, I did go over to one of the stockholders lawyer's office, 
the local office of Milberg, Weiss, Lerach et al., to have them show me the records 
that justified their fees. To justify 8,935 hours, they brought out a folder that was 
an Vs of an inch thick. This supposedly contained all their billings. Keith Parks of 
the firm said that the reason they had agreed to let me come over to their office 
was to see if they could talk me out of going back to the second hearing. 

On August 20, 1990, the Court approved the settlement and reduced the legal fees 
to roughly $3,300,000. At that hearing, an attorney for Milberg, Weiss, et al., in- 
formed the Court that they wanted to wrap up the case so that everyone, especially 
the shareholders, could be paid before the end of 1990. Stockholders' lawyers were 
paid their fees before the end of 1990. The stockholders were paid their settlement 
money on July 7, 1992, approximately 2 years after the settlement hearing and long 
alter the stockholders' attorneys were paid. 

Now what did the shareholders eventually get for paying their lawyers a little 
more than $3,300,000 in legal fees? 

At the time of the distribution of funds on July 7, 1992, there was approximately 
$5,800,000 left in the settlement fund after paying the attorneys' fees. The approved 
claims by the stockholders amounted to approximately $35,000,000. Basically, the 
stockholders recovered 17 percent of their losses. Of my $1,751.51 loss, I recovered 
$250.51. According to the accountants at Heffler & Co., the company who processed 
this claim and whose business it is to process securities class-action claims, this was 
a large recovery. The accountants said that in the vast majority of settlement recov- 
eries, the stockholders get less than 10 percent of their losses. 

Was there fraud in Pace? I do not know. All I have to go on is the Settlement 
Notice that was sent to the stockholders. The shareholders lawyers say there was. 
The defendants say there was not. 

If there was fraud, these defrauding officers and directors should have been held 
accountable. Instead, no one paid any money except the insurance companies. These 
costs ultimately get passed along in the form of higher insurance premiums to ei- 
ther the shareholders or to the company's customers. But in any event, the defraud- 
ing parties did not pay. 

If there was not a fraud, I am not interested in being part of legalized extortion 
of innocent companies who pay just to get rid of the lawsuit. If there was not fraud, 
I resent being used by the attorneys as their shill so that they can coerce millions 
in legal fees from companies who have not violated the law. 

II. Tucson Electric Power 

In January, 1992, I received notice of a settlement in a securities class-action case 
involving Tucson Electric Power. During the class period, I had bought and sold 300 
shares oi Tucson Electric Power, and had a loss of $5,595.56. Once again, I was the 
typical claimant that the law was designed to help. The Tucson Electric settlement 
was for $30,000,000, and the stockholders' lawyers were asking for 30 percent. As 
to be expected, I flew, at my own expense, to the settlement hearing in Phoenix to 
object to the legal fees and the settlement. 

On February 20, 1992, the Judge approved the settlement and awarded legal fees 
of approximately $7,845,000. The actual hourly costs of the shareholders' attorneys 
were a bit under $3,000,000.00. There were 177 lawyers and 77 paralegals/law 
clerks from 35 law firms representing the stockholders. There were 10,741 hours 
spent on this case by the shareholders' attorneys. (This was only the shareholders 
side of the case.) The highest hourly rate was $500. It was charged by Melvyn 
Weiss, of Milberg, Weiss, et al. 14 other lawyers charged between $400-$500 an 
hour, and 51 lawyers charged between $300-$400 an hour. However, the Court did 
not award the lawyers just their hourly fees of roughly $3,000,000, but awarded — 
them $7,845,000, or a bonus of approximately $4,845,000 above their hourly fees. 
(I am presently appealing the settlement and the award of legal fees with the U.S. 
Court of Appeals, again, at my own expense.) 

All the monies for the Tucson Electric settlement will come from insurance compa- 
nies. The defrauding officers & directors are long gone from the company. They will 
not be putting any money into the settlement fund. Prior to the settlement hearing, 
a number of shareholders had filed written statements to the Judge asking why the 



136 

corporate officers and directors were not held responsible. To this, the Judge said 
this was not a criminal prosecution, and that was the end of their accountability. 

For all this time and money, the shareholders' lawyers must be pretty good. So 
what can the shareholders expect to get from this settlement? According to the no- 
tice sent to the shareholders by their attorneys, the attorneys said the $30,000,000 
settlement would "confer substantial benefits to the Settlement Class and each of 
its members." After subtracting the legal fees, the settlement fund is approximately 
$22,000,000. At first blush, this might seem luce a lot of money for the stockholders: 
however, the shareholders suffered losses of between $200,000,000 and 
$400,000,000. The shareholders' attorney, Gary Cantor, told me that the sharehold- 
ers should expect to recover $.04-$.05 for every dollar of loss. Of my $5,595.56 loss, 
I should recover $279.78. Another great victory for the shareholders. Mr. Cantor had 
told me it would not be the biggest check I had ever gotten. I guess he was right. 

You tell me, for whose benefit are these lawsuits brought and then settled? Pace 
shareholders recovered $.17 of every dollar of loss, the stockholders' lawyers get 
roughly $3,300,000. Tucson Electric Power— shareholders get $.04-$.05 for every 
dollar of loss, the shareholders' lawyers get approximately $7,850,000. The share- 
holders might get more if the lawsuits went to trial, but it only stands to reason 
that 96 percent of the cases settle. It is in the best interests of the lawyers to settle. 
If a case goes to trial and the shareholders lose, not only do the stockholders not 
get anything, but the shareholders' lawyers do not get anything. Of course, if the 
case settles, the shareholders still get virtually nothing, but at least their lawyers 
make millions. Now if the case went to trial, the stockholders might just win their 
case and get their money back, but why should the lawyers take that chance when 
they can get so much in legal fees without going to trial. 

If Congress thinks this law is helping the stockholders— it isn't. The stockholders 
recover little. 

If Congress thinks this law is punishing and detering defrauding officers and di- 
rectors — it isn't. Insurance is paying the settlement amounts, which will then get 
passed along to consumers and stockholders. The defrauders don't pay anything. 
Plus innocent companies are swept up in these suits. They settle at 6 percent of 
the stock losses just to get rid of them, even if they are not liable. 

The only ones who benefit are the attorneys, and the way the system is 3et up 
it only encourages them. Why do you think the number of shareholders suits has 
been rising? Because officers and directors are more fraudulent today than last 
year? If that were the case, then certainly these cases are not a deterrent. 

The reason these cases are on the rise is because it is big money for the attorneys, 
and there is no opposition. Some small stockholders think they will get their losses 
back, so they don't oppose the settlement. For the small stockholders who do know 
how little they will get back, it is not worth their time and money to oppose the 
settlement. For the big stockholders, like mutual funds and pension plans, the 
money managers do not want to oppose the settlement and advertise that the man- 
agers made losing investments. The judge is too far removed to know what is best 
for the stockholders. The judge gets all of his information on what is good for the 
stockholders from the stockholders' attorney. That's like the farmer asking the fox 
who's guarding the chicken coop, how the chickens are doing. The defendants want 
to settle the case as it amounts to only 6 percent of the potential liability, and the 
amount is normally paid by insurance. The insurance companies are also looking 
at only 6 percent of the potential liability, and they pass these costs along in rising 
insurance premiums. Its a pretty neat scheme for the stockholders' attorneys. 

Possible Solutions 

Something needs to be done to the structure regarding the payment of legal fees. 
As the system currently exists, it encourages the filing of suits whether or not there 
was fraud. Further, it encourages settlements which give virtually nothing to the 
shareholders and do not penalize the defrauders. 

I propose that the shareholders' lawyers receive as fees the same percentage of 
the settlement fund that the stockholders recover of their losses. If the shareholders 
recover 50 percent of their losses, the lawyers get 50 percent of the settlement fund. 
But if the stockholders only get reimbursed 5 percent of their losses, then the law- 
yers only get 5 percent of the settlement fund. 

The lawyers expect to make 25 percent of a settlement in legal fees, even if their 
clients only get 5 percent. But let s suppose the rule is that the shareholders' law- 
yers get the same percent of fees of the settlement as the stockholders recover of 
their losses. If the lawyers want to continue with their 25 percent fees of the settle- 
ment, then the stockholders would have to recover 25 percent. So the stockholders' 
lawyers now go to the defendants and say they will settle, but it must be for 50 



137 

percent of the shareholders' losses. (25 percent goes to the lawyers, 25 percent goes 
to the stockholders.) Well, now the defendants are not as willing to settle. IT the 
defendants could buy off the lawsuit, whether or not there was merit, for 6 percent 
of the potential liability; it was worth it to settle. But if the settlement is for 50 
percent of the losses, then they might not want to settle and instead will take there 
chances at a trial. At this point, the shareholders' attorneys better have filed a case 
that is strong enough to prove fraud at a trial, because they probably will have to 
go to trial. With the potential of an actual trial, they would, or should, have made 
a determination when they filed their lawsuit that they had a strong case of fraud 
that they could prove at a trial. This formula for the payment of legal fees should 
result in the truly fraudulent cases being filed, and cut down on the meritless or 
worthless cases being filed. This should help unclog the courts. 

In Tucson Electric Power, the lawyers claim that because of the financial condi- 
tion of Tucson Electric Power, they could only recover 5 percent for the sharehold- 
ers. I wonder at what point in the 10,741 hours that the 177 lawyers and 77 para- 
legals put into this case, that they discovered this? How many hours at $500 an 
hour were spent after this was discovered? For every additional $10,000,000 the 
lawyers recovered in this settlement, the lawyers got $2,500,000 more in fees, while 
I recovered another $93.45. Do we really want to encourage these suits if that's all 
there is for the stockholders? In Tucson Electric Power, if the lawyers had only got 
5 percent of the settlement as fees, like the stockholders expect to recover of their 
losses, maybe the lawyers would not have brought the suit. Well, maybe they 
shouldn't have brought the suit. Maybe this is a matter for the SEC to handle. 
Could not the SEC achieve results at least as bad as this for less than $7,500,000? 
I think some of the stockholders would rather have seen the actual individual de- 
fendants held accountable. One of the defendants was making a million dollars a 
year in salary at the time of the fraud. 

I also propose that the notice that is sent to the stockholders regarding a settle- 
ment offer should specify what percent of their losses the stockholders can expect 
to recover. The notices as they are currently written only give the total amount in 
the Settlement Fund. That figure is irrelevant to the stockholders and is actually 
misleading. The only thing a shareholder cares about is how much of his or her 
losses are recovered, not how much is in the total settlement fund. In Tucson Elec- 
tric Power, the notice that was sent to the stockholders deceived them into thinking 
that they would recover a large portion of their losses. The notice stated there was 
$30,000,000 in a settlement fund, and that this settlement would "confer substantial 
benefits to the Settlement Class and each of its members." Since when is recovering 
5 percent of one's losses a substantial benefit. If recovering 5 percent of losses is 
substantial, then paying the lawyers 5 percent of the settlement as fees should also 
be substantial. 

Some of the items I think should be contained in a settlement notice are: 

1. A statement of the amount of the total losses or damages suffered by the stock- 
holders (The shareholders lawyers must know what the losses are in order to rec- 
ommend to the court that the settlement offer is reasonable, fair and adequate.), 

2. An example of how the total losses compare with the amount in the settlement, 

3. An example of what percent of losses the stockholder can expect to recover of 
his or her losses, 

4. A statement of what the average percentage of losses are recovered in securities 
class-action cases, 

5. A statement emphasizing the fact that the shareholders do not have to settle, 
and that they can proceed to trial and could recover more, 

6. A statement of the conflict of interest by the shareholders' attorneys that it 
vastly benefits the attorneys more than the stockholders to settle versus proceeding 
to trial, and an explanation of this conflict of interest, 

7. A breakdown of the attorneys' fees, i.e. the total billable hours they spent on 
the case; the number of law firms, attorneys, and law clerks/ paralegals represent- 
ing the stockholders; the hourly billing rates and the number of lawyers charging 
the various hourly billing rates. 

The stockholders have the right to opt-out of the settlement, or to approve or dis- 
approve the settlement and legal fees. Once the settlement is accepted, the stock- 
holders are barred forever from suing on this cause of action. I believe due process 
of the law requires that the stockholders be informed of these material facts in order 
to make a decision. 

I also propose that the lawyers get paid their fees the same time the stockholders 
get their distributions. Currently, the lawyers get paid shortly after the approval 
of the settlement hearing. For the stockholders, though, it often takes years after 
the settlement hearing for the stockholders to be paid. If the lawyers did not get 



138 

paid until the stockholders did, you would probably see the shareholders get paid 
much sooner. 

Finally, the officers and directors should be truly held accountable if they commit- 
ted fraud (and certainly not if they did not). Although the officers and directors 
would never be able to reimburse the stockholders for the massive losses that nor- 
mally occur in these cases, the stockholders would feel that, at least if they do not 
get their money back, the guilty people were held accountable. As the system is 
presently set up, the victims, the stockholders who lost their money through fraud 
are not compensated, and the offenders who caused the losses are not held account- 
able. The suits are really brought so that the shareholders lawyers can suck money 
out of insurance companies. 

My thanks to Senator Dodd and the other Members of this Subcommittee who 
gave me an opportunity to speak. 



PREPARED STATEMENT OF VINCENT E. O'BRIEN 

My name is Vincent E. O'Brien. I hold a Bachelor of Science degree in Electrical 
Engineering with High Honors from the University of Illinois, and Master and Doc- 
torate degrees in Business Administration from Harvard University. For the last fif- 
teen years, I have specialized in providing economic and financial analysis for attor- 
neys involved in complex litigation. I have worked for both plaintiffs and defendants 
and have testified in Securities Class Action cases. 

This experience has led me to believe that private enforcement of public policy 
under 10(dX5) indeed serves a useful propose. That, however, is not the question 
before this committee nor should it be. Instead, the appropriate question is whether 
the current law is working effectively to achieve it goals and whether it is doing 
so efficiently. To answer these questions, I have reviewed the various studies of 
10(bX5) litigation and conducted one of my own. These studies, I believe, reveal that 
the current situation provides little in the way of deterrence, fails to protect harmed 
shareholders, and imposes significant costs on relatively innocent defendants. In 
short, the studies are unanimous in saying that we have a serious problem that 
needs to be fixed. 

The most comprehensive study of 10(bX5) actions is my study which was first 
completed in 1991 and recently updated. 1 The views expressed here are strictly 
mine and are not necessarily those held by others at my current firm, the Law & 
Economics Consulting Group, Inc. located in Emeryville, Ca. 

This study focused on securities class-action cases in Federal courts involving pub- 
licly traded corporate stock. Actions involving non-profit institutions, municipalities 
or partnerships were omitted as were actions involving just bonds or those only be- 
fore state courts. I also limited my selection of cases to those involving the material 
misrepresentation or omission of information. 

My source for identifying these cases was a newsletter called THE SECURITIES 
Class ACTION Alert published by the Investors Research Bureau of Cresskill, N.J. 
It reports on the filing and progress of these cases and was first published in April 
of 1988. From that source, I was able to identify 533 securities class actions re- 
ported during the five-year period beginning in April of 1988 and ending in March 
of 1993. Additional data were then collected from a variety of public sources. 

The study revealed at least six general conclusions of interest to this committee. 
First, it is very common for corporations to be sued under this law. In just the five 
years covered by my study, one out of every eight companies traded on the New 
York Stock Exchange was sued. On the American Stock Exchange, one in eighteen 
was sued. On the NASDAQ, which lists over 4,000 stocks, one in twenty was sued. 
Altogether, 342 companies paid $2.5 billion in settlements over this period. 

Second, a disproportionate share of the cases were against young, medium-sized 
high technology firms. One third of the cases involved companies less than ten years 
old. Likewise, almost a third of the suits involved companies with sales under $100 
million and 61 percent involved companies with sales under $500 million. The high 
technology industries — consisting of electronics, computers, instruments and medical 
devices — accounted for one out of every four suits. 

Third, even though certain types of companies are prone to this litigation, almost 
any corporation is a possible target. Every industry, from entertainment to manu- 
facturing, had companies that were sued. Likewise, being a mature company didn't 
protect one from these suits as fully two-thirds of the sued companies were more 



X © K A Study of Class Action Securities Fraud Cases 1988-1993," by Vincent E. O'Brien and 
Richard W. Hodges. 



139 

than ten years old. Companies with over $10 billion in revenues were sued as fre- 
quently as their $10 million brethren. 

The one thing all of these companies had, though, was a drop in the price of their 
stock. While the average drop was 51 percent, companies with drops of less than 
10 percent were sued. Most disturbingly, companies who had a history of wide price 
swings, i.e., companies known to be risky investments, were much more likely to 
be sued. Because there is no reason to believe that fraud is significantly more preva- 
lent at such companies, this would suggest that these suits are being used as insur- 
ance for normal investment risk rather than to recover for injury due to fraud. 

The fourth major conclusion revealed by the study is that virtually all of these 
litigations are resolved through settlement. Out of 365 cases resolved to date, only 
five reached a jury verdict and 21 were dismissed or withdrawn. All in all, 93 per- 
cent of the securities class-action cases in my sample were settled out of court. This 
is an extremely high settlement rate as the norm for most other civil cases is 60 
percent to 70 percent. Over 30 percent of the cases are dismissed or dropped. In this 
way, cases that are weak or without merit are weeded out. This is not happening 
in securities class actions. Instead, we have a situation where it is common lor vir- 
tually every firm that is sued to be compelled to pay a settlement. 

The fifth conclusion revealed by the study is that individual investors get little 
direct benefit from the class-action suits brought on their behalf. Most of the share- 
holder losses are suffered by large institutional investors, and it is they who receive 
the bulk of the settlement fund. In the most extreme case I examined, five claimants 
out of 302 received 36 percent of the settlements. In another, 52 percent of the set- 
tlements went to 1 percent of the claimants; not one was an individual. While insti- 
tutional investors are entitled to equal protection under the law, it is important to 
note that the allegations of misrepresentation in these cases often involved informa- 
tion readily accessible by other means to these large, sophisticated investors. 

The sixth conclusion, and perhaps the most disturbing one, is that the settlement 
amounts in these cases are relatively low when compared to the losses. On average, 
the cash amount of the settlement was 6 percent of the total trading losses for pur- 
chasers of common stock during the relevant period. This is before their attorneys' 
fees, which can be a third of the recovery, are deducted. 

Not only are the plaintiffs not receiving much compensation, it is doubtful that 
these settlements are providing an efficient deterrence to fraud. Fully 40 percent of 
the settlements were for less than $2.5 million. This is less than the defendants' 
cost of taking one of these cases to trial. Settlement for less than the defendant's 
litigation costs is a indication that the case was weak or without merit as the plain- 
tiff is choosing to avoid a test of its merits in court. The bringing of weak or 
meritless cases almost by definition would have minimal deterrence effect. 

Another 43 percent of the settlements were between $2.5 and $10 million and an- 
other 13 percent were between $10 and $20 million. According to insurance industry 
data, the average corporate policy that covers this type of claim is between $10 and 
$20 million. I have also been told by practitioners in the field that these amounts 
are typical of payouts under Director and Officer liability policies. Settlements lim- 
ited to insurance coverage would offer little deterrence as the parties at fault rarely 
bear the burden of increased premiums. Thus, it would appear that in fully 94 per- 
cent of these cases, there is no chance that any deterrence has been achieved. 

There are three other studies that address securities fraud litigation and they are 
all consistent vrith the results of my study. The first one was done by Janet Cooper 
Alexander at the Stanford University School of Law. 2 Professor Cooper Alexander 
examined litigation arising out of seventeen initial public offerings (IPOs) of stock 
by similar computer firms in the first half of 1983. Professor Cooper Alexander 
found that 9 of the 17 companies that made IPOs in this period were sued (includ- 
ing the 6 largest offerings with the largest declines in value). Every company that 
suffered a market loss of at least $20 million was sued. Since all other factors were 
essentially the same for these offerings, and since some proportion of IPOs can be 
expected to do poorly, Professor Cooper Alexander concluded that the suits likely 
varied on the strength of their claims of fraud. She then found that 8 of the 9 suits 
settled before trial and the ninth was expected to settle rather than proceed to trial. 
Importantly, not one of these cases was resolved on the merits by summary judg- 
ment or dismissal. Virtually all of the settlements fell within the same range when 
expressed as a percentage of the stakes (market losses suffered). When she found 
that the settlements were similar in nearly every case — 24.5 percent to 27.5 percent 



2 Do the Merits Matter? A Study of Securities Class Actions," Janet Cooper Alexander; Stan- 
ford Law Review; Vol. 43, No.3, February 1991. 



140 

of the computed losses to shareholders — she concluded that the cases had settled 
without regard to their merits. 

When Professor Cooper Alexander's conclusion was released it met with a hail- 
storm of criticism. This came almost entirely from practitioners in the field, includ- 
ing both plaintiff and defendant counsel. Much of this criticism doesn't merit repeat- 
ing but one point does. By constructing a homogeneous sample, the study runs into 
sample size problems. The critics argue that there are just too few cases from which 
to draw the conclusion that the merits don't matter. This misses the point: the study 
failed to prove that the merits do matter. 3 Since the merits obviously should matter, 
this failure to uncover any indication that the system takes account of the strength 
of a claim should alarm everyone concerned with securities law. 

Another study was done by an economist, Frederick C. Dunbar. 4 It extended my 
initial study to the two year period ending in June of 1992 with many of the same 
results. Dunbar did, however, find that Both the number and size of settlements 
were increasing. He also found that settlements amounted to approximately 3 per- 
cent of shareholder losses. 

A third unreleased study has been prepared by Zoe-Vonna Palmrose, an Associate 
Professor at the University of Southern California. 5 In it she examines 460 securi- 
ties actions filed against auditors from 1960 to 1992. Her study shows that in 65 
percent of these matters, the auditors paid less than $1 million. Given an average 
defense cost of $3.5 million, she concludes that the plaintiffs' cases were weak. 

I believe that the conclusions that one should draw from these studies are clear. 
First, there is way too much of this type of litigation. With one out of every eight 
NYSE firms having been sued in the last five years alone and virtually all of them 
paying a settlement fee, one has to be concerned. It seems most unlikely that Amer- 
ican companies are engaging in fraud on such a massive scale (and that plaintiffs 
are able to pick their targets with such pinpoint accuracy). Rather, something is 
forcing innocent defendants to settle rather than fight meritless changes. Second, 
with such indiscriminate filing and settlement, the current law is providing little 
deterrence. A remedy that can be invoked with essentially the same level of success 
in virtually every case, regardless of the true merit of the claim, does not single out 
malefactors and force them to bear an especially heavy burden — either in economic 
terms or in terms of the public opprobrium that would accompany an adverse judg- 
ment or large settlement under a more discriminating system. It therefore provides 
much less of a deterrent to wrongful conduct. Third, with shareholders recovering 
only a few cents on the dollar, the law is not providing any significant compensa- 
tion. 

I believe that these problems are peculiar to 10(bX5) type of actions. In civil cases, 
thirty to forty percent of all actions are terminated without trial or settlement. 
Weak cases are fought by defendants and weeded-out through the normal judicial 
process by dismissal (voluntary or involuntary) and summary judgment. As the 93 
percent settlement rate shows, that does not happen in securities class actions. 
What is needed are remedies that would change the system to encourage plaintiffs, 
to press only meritorious claims and encourage defendants to resist non-meritorious 
ones. 

One remedy, proportional liability, has been proposed. I believe that proportional 
liability would help by discouraging suits against peripherally involved parties and 
by encouraging those parties not to settle. Currently, the threat of joint and several 
liability is a strong inducement for innocent defendants to settle, since even those 
with minimal involvement in a transaction can be forced to pay the full amount of 
damages (this is a particular problem in cases where more substantially involved 
defendants are no longer solvent). Ensuring that liability is apportioned according 
to relative culpability among defendants would allow those defendants to resist the 
pressure to settle; a credible prospect of trial on the merits should restore some vi- 
tality to merits-based litigation and settlement strategies. However, I do not believe 
that this proposal by itself would be enough to correct the current situation. 

I believe that the committee should carefully examine the premise and purpose 
of the existing law to insure that only behavior likely to injure shareholders or 
interfere with markets is proscribed. Under the current law, almost any 



3 Professor Cooper was trying to test the null hypothesis that the merits do not matter. Since 
she couldn't reject this hypothesis, considerable doubt is placed on the alternative hypothesis 
that they do. This is an important finding. 

4 "Recent Trends In Securities Class Action Suits," Frederick C. Dunbar; National Economic 
Research Associates, Inc.; August, 1992. 

6 The Joint and Several Versus Proportionate Debate: An Empirical Investigation of Total 
Resolutions on Audit-Related Litigation," Zoe-Vonna Palmrose, working paper, University of 
Southern California; January, 1983. 



141 

misstatement or omission by a firm's management can lead to a suit being filed and 
a settlement being paid. However, management is only one source of information 
to investors. Large, sophisticated investors expend a great amount of time develop- 
ing their own facts and assessments about a firm. It is through this process that 
the markets are compelled to accurately reflect all available information. 

Since other shareholders are actively gathering their own information and making 
their own assessments, the law does not need to protect shareholders from every 
statement made by management. It need only concern itself with information that 
is not reasonably available outside the firm. Thus, statements about customers, sup- 
pliers, existing products, etc. need not concern us. The financial markets can and 
will gather accurate information from their own sources on these issues. 

Likewise, statements about the future should normally not concern us. These are 
known to be inherently speculative and investors are usually in as good a position 
to make a forecast as management. By limiting actions to misstatements and omis- 
sions that are likely to cause injury, this committee could greatly reduce the number 
of firms being sued and focus the law on cases of real fraud. 



TESTIMONY OF WILLIAM S. LERACK 
Milberg Weiss Bershad Hynes & Lerach 

Chairman Dodd and Members of the Subcommittee. My name is Bill Lerach, and 
I am a partner in the law firm of Milberg Weiss Bershad Hynes & Lerach, resident 
in our San Diego office. I am also the Immediate Past President of the National As- 
sociation of Securities and Commercial Law Attorneys ("NASCAT"), a trade associa- 
tion and public policy voice of approximately 90 law firms and several hundred law- 
yers committed to a strong system of Federal and state legal protections for inves- 
tors and consumers. 

For the past 22 years, I have practiced commercial litigation. For the past 17 
years, I have been involved almost exclusively in plaintiffs class action and stock- 
holder derivative litigation. I or my partners have served or am serving as co-lead 
counsel in a number of nationally prominent cases, including those on behalf of the 
victims of the scandals involving many publicly-owned savings and loans, Executive 
Life Insurance, Drexel Burnham Lambert, and the Bank of Credit and Commerce 
International. Over this period of time, I have also written and taught extensively 
in the areas of securities law and class-action litigation. 

I appreciate your extending me the opportunity to testify this morning. The issues 

Sou are considering are vitally important because they affect the interests of the 
undreds of thousands of victims of financial fraud in every state who will be left 
without any means of recovering their losses if Congress guts private enforcement 
of our securities laws. 

At the outset, let me be direct: The proposals this Subcommittee will be asked 
to consider to change the rules for securities fraud litigation — as embodied in 
H.R.417 this year and S.3181 in the last Congress — are unfair, unwise, and totally 
unnecessary. 

These proposals are unfair because they would effectively end all securities class 
actions brought by victims of fraud. Tens of thousands of people, many of them re- 
tirees living on fixed incomes, are swindled each year by the likes of Ivan Boesky 
and other financial crooks. The proposals you are considering today would slam the 
courthouse door in the faces of these victims, while letting financial predators and 
their professional accomplices off the hook. Ivan Boesky, David Paul, Fred Carr and 
many savings and loan executives and their accountants, lawyers, and investment 
bankers would love these proposals. Their victims would not. 

These proposals are unwise because, by shielding wrongdoers from accountability, 
they would weaken deterrence of financial fraud at a time when we need to be 
strengthening law enforcement efforts. There is more financial wrongdoing today 
than at any time in this century. Adopting these proposals would lead to even more 
fraud, raise costs to American taxpayers and reduce public confidence in the finan- 
cial marketplace, thus impairing capital formation. 

Finally, these proposals are unnecessary because there is no evidence to support 
the claim of an epidemic of frivolous lawsuits. I realize it would be unseemly for 
proponents to come here honestly and say they would like special legislation to pro- 
tect them from the people they have defrauded. But it would surely he more honest 
than using the spurious claim of frivolous suits as their rationale for this legislation. 

Let us be frank: The principal proponents of these proposals are business wrong- 
doers and defendants in fraud cases who simply do not like the concept of legal and 
financial accountability. Earlier this year, the Wall Street Journal reported that the 



s 



142 

Big Six accounting firms had each contributed $2 million to lobby for limits on suits 
by victims of fraud. All of these firms are and have been defendants in major fraud 
cases, and five of them were banned by the RTC from thrift reorganization work 
in 1990 for failing to perform their audits of S&Ls in a professional manner. Accord- 
ing to court documents, one of these firms alone — Ernst & Young (or its prede- 
cessors) — audited approximately one-third of the 690 financial institutions that have 
failed. No wonder they want fewer lawsuits. 

The Evidence Does Not Support Calls for Change 

The facts are that class-action securities suits are not exploding in number, nor 
are these suits abusive. Several procedural rules exist to promptly dismiss meritless 
suits, to eliminate weak cases via summary judgment and to impose sanctions on 
lawyers who file frivolous suits. The interests of the class members — the victims of 
securities fraud — are also scrupulously protected by the courts in class litigation. 
Further, securities fraud suits do not harm the economy or restrict capital forma- 
tion; in fact, the opposite is true. 

Let me address each of these points in more detail. 

Suits Are Not Exploding in Number 

The evidence simply does not support the contention that securities suits are ex- 
loding in number. Although the number of securities class actions increased in 
990, this was hardly remarkable given the enormous upsurge in public offerings 
and securities trading in the late 1980s. However, there were still fewer securities 
class actions filed in 1991 (256) and 1992 (268) than in 1974 (305). Furthermore, 
even counting all class-action suits (and in 1992 securities class actions comprised 
less than 25 percent of those), such actions accounted for less than 0.5 percent of 
all new Federal court filings over the past 10 years. And there were about the same 
number of securities class actions pending in Federal court in 1992 (642) as in 1973 
(631), 

It is worth remembering that many of the largest suits against accounting firms 
in recent years were brought by the U.S. Government and arose out of the collapse 
of savings and loans. These were not class actions under the securities laws and 
these suits will not be affected in any way by legislation this Subcommittee may 
consider. The accounting profession is trying to use the statistical and monetary im- 
pact of these huge Government suits against them to claim litigation is exploding 
and threatening their industry. Their goal is to eliminate private suits by investors 
for securities fraud, which have remained relatively constant. This is disingenuous 
in the extreme. 

Ample Legal Safeguards 

While I would never assert that no frivolous securities fraud lawsuit has ever 
been filed, there are ample legal safeguards in place to protect against unwarranted 
actions: 

• Pro forma complaints are not allowed in securities fraud suits. Federal Rule of 
Civil Procedure 9(b) requires that securities fraud claims be pleaded with particu- 
larity and that each defendant's role in the illegal fraud be set forth in detail. 

• Federal Rule of Civil Procedure 11 already permits a court to impose sanctions, 
including having plaintiffs' lawyers pay a defendants legal fees, for any complaint 
filed without adequate investigation and factual basis. Millions of dollars in Rule 
11 sanctions have been imposed since the rule was strengthened in 1984. This in- 
cludes sanctions even against Government attorneys; in the National Bank of 
Washington case, the FDlC was recently ordered to pay the defendants' legal fees. 
Many respected voices believe Rule 11 is so restrictive that it chills innovative, 
as well as meritless, litigation. In response, the Judicial Conference has proposed 
an overhaul of the rule in order to give more flexibility to judges. 

• Section 11 of the Securities Act of 1933 also allows a court to levy sanctions for 
meritless suits. 

In fact, securities lawsuits that lack merit are promptly dismissed or disposed of 
by way of summary judgment, and Federal courts increasingly impose sanctions on 
attorneys who file such suits. 

Access to justice for those victimized by fraud is a cornerstone of our judicial sys- 
tem and a right provided by the anti-fraud provisions of the securities laws. The 
real issue is how to deal with meritless or frivolous lawsuits. Can meritless suits 
be promptly dismissed? Are those who file frivolous lawsuits punished? If the an- 
swer to these questions is yes, it would appear that the current system is, in fact, 
separating wheat from chaff, thus permitting investors victimized by fraud who 
state well pleaded claims to go ahead on the merits while, at the same time, protect- 



143 

ing defendants from having to defend meritless claims and inflicting appropriate 
punishments on those who abuse the litigation process by filing frivolous claims. 

There is widespread agreement that in recent years courts have been more willing 
to dismiss securities fraud lawsuits on the pleadings. The Wall Street Journal 
reported last year that a number of companies "have had unusual success in defend- 
ing charges they defrauded investors," by obtaining outright dismissals and/or sum- 
mary judgments. A recent study by National Economic Research Associates, Inc. 
concluded that ". . . the percentage of cases dismissed has also increased signifi- 
cantly," and Harvey Pitt, a leading lawyer for defendants in securities cases, has 
written that "(F)ederal courts have displayed a striking willingness to dismiss these 
suits." 

The courts decide class-action cases on a daily basis and are capable of dealing 
with any apparent abuses. What is going on here is good — judicial evolution. As 
SEC Commissioner Richard Roberts stated just a week ago: 

While I do believe that meritless securities litigation is a problem, I am not a 
supporter of the current legislative attempts to achieve securities litigation re- 
form. I prefer the reform that is already taking place judicially. Rule 11 sanctions 
are now beginning to be level led by courts against both plaintiffs and defendants 
for taking meritless positions. Further, if certain amendments to the Federal rules 
of civil procedure are adopted as recommended by the Federal judiciary, Rule 11 
will probably be invoked even more frequently. Moreover, the Supreme Court re- 
cently has narrowed the application of the civil liability provisions of RICO and 
has affirmed the right of defendants to seek contribution from persons who were 
jointly responsible with them for securities law violations. 

These reforms, already taking place within the parameters of our existing litiga- 
tion system, make a lot more sense to me than the well-intentioned but misguided 
legislative vehicles currently being bounced around. I would rather encourage con- 
tinued progress on the judicial reforms underway than to engage in the ill-fated 
legislative pursuit of such worn tort reform concepts as a loser pays rule or a com- 
parative negligence standard. 

Thus, I would argue that no new laws are necessary to curb "abusive" suits; 

{'udges already have the tools to address the few situations in which complaints are 
>rought without sufficient basis. More important, I believe that any attempt to craft 
broad-based legislation to reach an extremely limited number of fact-specific cases 
of supposed "abuse" is certain to eliminate meritorious cases as well. 

Class Members Are Scrupulously Protected 

The Federal Rules protect the class members as well as the defendants in securi- 
ties fraud cases. Indeed, in no area of our legal system are the interests of the client 
more scrupulously protected than in class-action litigation. Under Rule 23(c), no 
case may proceed as a class action unless the class is approved by a court after no- 
tice to class members. Also, any class member has the right to opt out of the class 
and file an individual action against the defendants if he or she is dissatisfied with 
how the case is handled. This rarely happens. 

Furthermore, the court can approve a settlement or award attorneys' fees only 
after written notice to the class and a public hearing at which class members must 
be afforded a full opportunity to voice any objections. And class members can appeal 
if they want to. Under Rule 23(e), a class action may not be settled, in whole or 
in part, without the express approval of the court. In fact, any award of attorneys' 
fees must be made by the court. 

This system has, in the main, worked well. It is important to remember that only 
that portion of a victim's market loss attributable to fraud can be collected as dam- 
ages under the securities laws. One prominent damage expert has concluded, based 
on a survey of 20 recent cases, that, on average, 27.7 percent of market losses are 
due to fraud and are legally recoverable. See Exhibit 1. When you put that figure 
together with the statistics prepared by claims administrators that have been sub- 
mitted to the Subcommittee, you can see that claimants receive about 60 percent 
of their recoverable damages after attorneys' fees. See Exhibit 2. I believe that this 
is an extremely good result. 

In some cases, the recoveries on a percentage basis have been strikingly higher. 
We recently had a savings and loan case that involved multiple defendants that is 
a notable example. Ultimately, a number of the defendants in the case settled; some 
did not. We won one of the largest verdicts in history against the remaining defend- 
ants. Although the principal wrongdoer and his company are now bankrupt, when 
all is said and done, I'm confident that class members in this case will receive close 
to 100 percent of their losses — even after deducting our attorneys' fees from the re- 
covery. Without the class-action suit — and without joint and several liability — there 



144 

would have been no recovery at all for the victims of one of the worst financial psy- 
chopaths of recent years. 

It is also important to note that the most comprehensive survey of fee awards in 
securities class actions ever made demonstrates that attorneys' fees — and costs — 
have averaged only 15.2 percent of all recoveries. The survey, involving 334 securi- 
ties class actions filed between 1974-1990 in which over $4 billion was recovered, 
was conducted by the authoritative journal Class Action Reports. See Exhibit 3. 

Securities Suits Help The Economy 

Let me turn now to the suggestion that securities fraud suits harm the economy 
or restrict capital formation. That is patent nonsense. Despite the adverse economic 
conditions of recent years, securities offerings by public corporations, Wall Street 
fees and profits are at all time highs. Corporate executive salaries (and stock op- 
tions) have also reached record heights (with countless executives of public compa- 
nies making over $1 million a year) — levels many commentators and shareholders 
would term grossly excessive. 

Stock and oond underwriting reached a record $588.8 billion in 1991, and has con- 
tinued to increase. Stock offerings more than tripled from 1990 to 1992 (from $19.1 
billion to $72.8 billion). Initial public offerings nave increased from $10 billion in 
1990 to $39 billion in 1992, and last Saturday's New York Times reported yet new 
record levels of IPO's for 1993. Stock trading activity on the New York Stock Ex- 
change and NASDAQ has also increased by 50 percent during this time period. Tak- 
ing a longer term perspective, the statistical comparisons are even more dramatic. 
Annual stock trading volume on the New York Stock Exchange and NASDAQ has 
increased by over 1400 percent since 1973. Proceeds of initial public offerings have 
increased nearly 2700 percent in the same period. Proceeds of all common stock of- 
ferings have increased over 1200 percent in the same period. See Exhibit 4. 

Not only is capital formation and securities trading actually flourishing, but Wall 
Street has never been more profitable. Buoyed by the new stock offering boom and 
trading explosion, securities firms had record pre-tax profits of more than $6.7 bil- 
lion in 1992, an increase of more than 15 percent over the record 1991 profits of 
$5.8 billion. One U.S. investment bank alone — Goldman Sachs — earned a pre-tax 
profit of $1.15 billion in 1991, and reportedly even more in 1992. 

Clearly, the economy and financial markets have not suffered because of securi- 
ties fraud class actions. It is simply inconsistent with these macroeconomic figures 
to assert credibly that the 250 or so new securities class actions filed each year are 
interfering in any measurable way with a multi-trillion dollar economy. 

Moreover, class-action suits generate very significant tax revenues for the Federal 
Government. The billion-dollar plus of class-action settlement funds generally in ex- 
istence at any one time are invested in U.S. Treasury bonds pending receipt and 
processing of claims and distribution of the funds. In addition, these funds earn in- 
terest and pay Federal income taxes on that interest. As best we can tell, taxes paid 
by class-action settlement funds to the Federal Government from 1988 to 1992 to- 
taled approximately $100 million. If securities class actions are wiped out — the sure 
result oi legislation like H.R.417 or last year's S. 3181 — this ongoing stream of tax 
revenue will be lost to the Federal Government. 

Finally, as a just-published article in the Securities Regulation Law Journal has 
pointed out, limitations on private securities fraud suits would also have serious re- 
percussions for pension ana retirement plans, which typically receive 35-55 percent 
of the distributions from our cases. In fact, according to the authors, employee-spon- 
sored retirement plans, representing over half of the U.S. workforce, are perhaps 
the most significant beneficiaries of class-action recoveries. 

Because these pension funds are effectively subsidized by the Federal tax laws, 
the Treasury has a vital stake in these cases as well. The authors of the article note 
that an ill-considered attempt to limit victims' rights could "bring about an economic 
disaster that would surpass the savings and loan fiasco." They conclude: 

If there is a loss of public confidence in the Nation's ability to provide private 
as well as public enforcement remedies as a deterrent against corporate mis- 
conduct, pension fund plan managers, along with other investors, will be reluctant 
to invest in the stock of both new and mature corporations. This would, in turn, 
result in a diminution in the ability of these companies to raise the capital needed 
for growth, expansion, or job creation. 

There is also strong reason to believe that class-action suits have actually helped 
the economy by providing a powerful disincentive to fraud and assuring the integ- 
rity of the marketplace, thus fostering capital formation. Without question, limita- 
tions on private fraud suits would erode confidence in the capital markets, reduce 
investment, and increase the cost of capital for U.S. business. 



145 

Former SEC Chairman Richard Breeden has stated unequivocally that weakening 
the protections against fraud could have serious consequences for the securities 
marketplace. Breeden wrote last year that: 

Private suits under Section 10(b) of the Securities Exchange Act and Rule 
10(b)(5) thereunder . . . are instrumental in recompensing investors who are 
cheated through the issuance of false and misleading information or by other 
means. When corporate officers, accountants, lawyers or others involved in the op- 
eration of a public company deceive investors for their own benefit, they should 
be held accountable for their actions. If this were not the case, investors would be 
far less willing to participate in our securities markets. This would limit the most 
important source, and raise the costs, of new capital for all American businesses. 

The scandals involving Boesky, BCCI, Salomon and the Treasury markets, and 
the Nations S&L's and insurance companies, among others, highlight the impor- 
tance of effectively policing the business and financial communities. 

One of the witnesses here this morning, SEC Enforcement Director McLucas stat- 
ed in March that there is "still a steady stream of insider trading cases" and that 
instances of accounting financial fraud have actually increased. Now is obviously not 
the time to reduce enforcement of the securities laws. 

Unfortunately, the SEC and the Justice Department cannot do the job on their 
own. The Supreme Court, Congress, the SEC, and the state securities enforcers 
have all recognized that private lawsuits are an essential supplement to Govern- 
ment enforcement of the securities laws, particularly in an era of deregulation and 
shrinking budgets. As a Federal court recently stated in a fraud case successfully 
brought against the Public Service Company of New Mexico: 

The most effective control and deterrent to over-reaching and wrongful conduct 
in the capital raising area is the presence of private lawyers who are willing to 
devote their time, their energy, and their own personal resources to vindicate the 
rights of individual investors who have been importuned, misled, or who somehow 
have been fraudulently deprived of their money. In re Public Service Co. of New 
Mexico, No. 91-0536M (S.D. Cal. July 28, 1992), at 8. 

In the past four years, Federal Government enforcement efforts have been sub- 
stantially reduced, in part because of budget constraints and also for political and 
philosophical reasons. Administrative and reorganization problems at the RTC have 
caused further problems and have derailed a number of cases. President Clinton's 
FY 1994 budget proposes further SEC staff cuts. According to the SEC, these cuts 
will mean that "complex investigations of Wall Street wrongdoing may take longer 
and some smaller ones may never begin. Cases most likely to be affected by those 
delays include those involving complex frauds, such as market manipulation 
schemes, or cases raising difficult accounting and auditing issues." 

The North American Securities Administrators Association (NASAA) — represent- 
ing the state enforcers of the securities laws — has also recognized the essential role 
that suits by victims of fraud play, pointing out that "resource restrictions at the 
state and Federal levels argue in favor of broader private remedies, not the oppo- 
site." NASAA's concern — like ours — is that, by effectively eliminating private en- 
forcement, bills like Hit. 417 or last year's S. 3181 would open the floodgates to 
rampant marketplace fraud. As then-NASAA President John Perkins testified before 
this Subcommittee in 1991: "No one — save those who committed fraud in the first 
place — benefits from ... [a] wholesale assault on private rights action." 

Imposing The English Rule and Limiting Joint and Several 
Liability Would End Suits by Victims of Fraud 

Let me now address the major proposals that have been put forward by the pro- 
ponents of changes in our present securities litigation system — adoption of the so- 
called "English Rule" and abrogation of the concept of joint and several liability. 

In short, imposing the "English Rule" — under which the loser of a suit might have 
to pay the winner's legal fees — would close the courthouse door to almost all victims 
of fraud. 

By definition, a securities class action is a suit brought by one or a few investors 
who have lost a relatively small amount of money ana who sue in a representative 
capacity on behalf of all victims who were similarly-injured. The legal expenses for 
such a suit will, of necessity, be totally disproportionate to the individual losses of 
the individual victims who sue as class representatives. No one victim could stand 
up and sue as the champion of the class tor his or her small loss if the risk was 
paying millions in fees of well-heeled insurance companies, public corporations, in- 
vestment banking houses, accounting firms and law firms. 

Without class-action suits, large-scale securities frauds cannot be remedied. Many 
modern securities frauds involve nationwide activities with multiple wrongdoers. 



146 

Victims who have lost even many thousands of dollars due to the fraud cannot af- 
ford individual litigation to try to recover a loss of that size. The cases are too com- 
plex, too big and too vigorously defended to be remedied other than on a classwide 
basis. Thus, if any remedy for the individual investor is to exist, the class action 
must be available. 

Moreover, there is already a substantial economic risk on the plaintiffs' side in 
bringing a securities class action, which helps screen out meritless or even marginal 
cases. Unlike defense lawyers (who are paid, by the hour regardless of the outcome), 

{ plaintiffs' counsel in securities class-actions litigate entirely on a contingency basis. 
f the plaintiffs lose the case, their attorneys receive no fees. Plaintiffs' counsel must 
also advance substantial out-of-pocket costs in order to prosecute the suits, which 
are not reimbursed if the case is lost. 

For 200 years, the United States has used the American rule, with each side gen- 
erally paying its own fees and costs. This constitutes a national policy in favor of 
access to justice, the rationale for which was stated by Chief Justice Earl Warren: 

[Ajlthough some American commentators have urged adoption of the English 
practice in this country, our courts have generally resisted any movement in that 
direction ... In support of the American rule, it has been argued that since liti- 
gation is at best uncertain one should not be penalized for merely defending or 
prosecuting a lawsuit, and the poor might be unjustly discouraged from institut- 
ing actions to vindicate their rights if the penalty for losing included the fees of 
their opponents' counsel. Fleischmann Distilling Corp. v. Maier Brewing Co., 386 
U.S. 714, 717-18 (1967). 

It is also worth noting several points about the operation of the English Rule in 
England. Importantly, the rule there results in a straightforward cost-shifting situa- 
tion for only a fraction of all plaintiffs. A safety net — a Government-funded legal aid 
scheme (accessible to more than half of the population) — cushions the effect of the 
rule. No one covered by legal aid, nor the legal aid system itself, is required to pay 
the winner's fees and costs. Moreover, a highly active trade union movement also 
cushions the rule; in cases involving a plaintiff supported by a trade union, the 
union bears any costs involved, including any penalties for losing. 

These safety nets in Britain effectively leave only middle income individuals sub- 
ject to the English Rule, and often they cannot contemplate suit even if their claims 
are valid. Because of that, there is evidence of a retreat from the English Rule in 
Britain, utilizing flexible and, in some cases, contingency fees. We should not be em- 
bracing this rule at the very time England is pulling away from it. 

Limiting joint and several liability would mean less accountability for those in- 
volved in complex commercial wrongdoing — and less justice for victims of fraud 
seeking to recover what was stolen from them. 

Under Rule 10(b)(5) (the basic anti-fraud provision promulgated by the SEC under 
the Securities Exchange Act of 1934), each defendant who conspires to commit a vio- 
lation is jointly and severally liable for all damages resulting from the violation. 
This rule represents the uniform view of the Federal courts and is consistent with 
traditional tort law. 

The reason for joint and several liability is that a conspiracy cannot succeed if 
one of the members of the conspiracy reveals its existence. To that extent, all con- 
spirators are equally culpable if the conspiracy achieves its aims. Moreover, com- 
plicated commercial crimes cannot by their nature succeed without the willing par- 
ticipation of professional "facilitators." As Harvard Law Professor Arthur Miller has 
testified, "the perpetuation of a complex financial fraud is impossible without the 
active assistance of professionals such as investment bankers, lawyers, and account- 
ants who must be held accountable." 

Quite simply, abrogation of joint and several liability would unfairly burden the 
innocent plaintiff when one or more of the defendants are incapable of paying their 
allocated portions. 

Perhaps the most striking example of the importance of joint and several liability 
is a recent major savings and loan collapse. Outside auditors frequently gave the 
savings and loan and its parent company a clean bill of health year after year while 
collecting huge fees; they allowed the principal perpetrators to keep Federal regu- 
lators at bay while they systematically defrauded elderly investors and bondholders. 
As happens all too often, the main villain and his company are now bankrupt. With- 
out joint and several liability, these thousands of victims would have had no ability 
to recover their losses. The operation of joint and several liability allowed us to re- 
cover the losses of 23,000 bondholders who suffered a loss of $240 million. Who 
should suffer the risk of loss in such a situation — the victims of the fraud or the 
conspirators in the wrongdoing? Surely the latter. 



147 

A recent Supreme Court decision further undermines the need for Congressional 
changes in joint and several liability. In Musick, Peeler & Garrett v. Employers In- 
surance of Wausau, 1993 WL 179262, decided on June 1, 1993, the Supreme Court 
held that defendants who compensate victims in a securities fraud action have a 
right to seek contribution as a matter of Federal law from their co-conspirators, who 
may have paid nothing at all or less than their "fair" share. Therefore, accountants 
and others who believe they have been forced to pay victims of fraud more than 
their proportionate share can sue their cohorts who had joint responsibility for the 
violation for contribution. There is no reason that the innocent victims of the fraud 
should be penalized or even involved in this effort to apportion blame among the 
conspirators. 

More help may be on the way for accountants and lawyers. Just last week, the 
Supreme Court granted certiorari in Central Bank of Denver, NA.. v. First Interstate 
Bank of Denver, ALA., No. 92-854, to determine whether parties like accountants 
and lawyers can be sued for "aiding and abetting" a securities fraud. The decision 
in this case could grant additional protections to professionals from being sued for 
assisting their clients to commit securities fraud. 

According to the General Accounting Office, when all categories of professionals 
are considered, RTC attorneys suspect wrongdoing on the part of one or more pro- 
fessionals affiliated with over 80 percent of failed thrift institutions. Elimination of 
joint and several liability would essentially relieve the accountants and other profes- 
sionals of their responsibility for participation in the savings and loan crisis and 
other complex frauds. Given their shocking record of misfeasance, malfeasance, and 
outright thievery in recent years, there is no public policy reason for shielding these 
professional facilitators from liability for their wrongdoing. 

You need not accept my view on this. Virtually every key player involved in the 
regulation of financial institutions has emphasized that commercial fraud would be 
impossible without the complicity of the professional assistors. 

Former SEC Chairman Breeden has written: 

[Securities fraud actions against accounting firms that participate in or assist 
fraudulent activity by not properly performing their auditing functions are impor- 
tant to the maintenance of high standards of quality and integrity among public 
accounting firms. Investors rely heavily on the accuracy of audited financial state- 
ments of public companies, as do creditors, investment analysts and others. When 
auditors fail to adhere to generally accepted accounting principles or generally ac- 
cepted auditing standards, many innocent parties may suffer. Indeed, inaccuracies 
in audited financial statements of banks and savings and loans have contributed 
to billions of dollars in investor losses over the past ten years. Public policy should 
seek to maintain high expectations of integrity and accuracy in the performance 
by auditors and accountants of their tasks. 

Federal District Judge Stanley Sporkin, in his opinion in one savings and loan 
case, wrote: 

Where were these professionals, a lumber of whom are now asserting their 
rights under the Fifth Amendment, when these clearly improper transactions 
were being consummated? Why didn't any of them speak up or disassociate them- 
selves from the transactions? Where also were the outside accountants and attor- 
neys when these transactions were effectuated? 

Later in a speech, he followed up: "For this kind of massive, very sophisticated 
fraud to have occurred, it required the complicity of certain professionals that we 
all know of— CPAs, lawyers, appraisers. I'm suggesting that perhaps these profes- 
sionals did not discharge their responsibilities to the broader public interest." 

In a speech before the American Bar Association, Timothy Ryan, former Director 
of the Office of Thrift Supervision, stated: 

The Federal agencies have uncovered actionable abuse in a third of the failed 
thrifts investigated to date. It is clear that many of the unlawful schemes hatched 
at those failed institutions could not have proceeded without the active assistance 
of professional service providers, especially lawyers. They have abandoned their 
ethics for expediency, and sold their good name to satisfy their greed. 

Finally, even the oversight board for the accounting profession's trade association 
admits that "the litigation problem cannot be considered apart from the widespread 
feeling in many quarters that independent auditors as a group have not met either 
their audit responsibilities or the expectations of investors and creditors as fully as 
they should." 

I understand why the accounting profession and their insurers are not happy 
that, when their fellow fraud conspirators go to jail, seek bankruptcy protection, or 
flee the country, they have been required to pay a substantial portion of the dam- 



148 

ages. But you should not be sympathetic. The alternative is leaving altogether inno- 
cent victims without compensation. Our recent financial history shouts the need for 
a bigger club held over the heads of the auditors, not a wink and a pat on the back. 
I believe that the existing system works well. By and large, I think it's very dan- 
gerous to tinker with a system that has so successfully fostered economic growth, 
capital formation and the orderly operation of securities markets. And I believe the 
proposals I have just discussed are manifestly unwise and dangerous. 

Victims Need Stronger Protections 

After all that has transpired on Wall Street and in the S&L industry, it is surpris- 
ing that Members of the United States Senate are considering how best to protect 
accountants, securities dealers, and business executives who are being held liable 
for wrongdoing. 

I had hoped instead that the Senate would be looking for ways to better protect 
the wrongdoers' victims — the individual investors and the integrity of our Nation's 
financial markets. 

When it comes to financial fraud, the problem has not been too much professional 
accountability, but not enough. The problem has not been too much law enforce- 
ment, but not enough. The problem has not been too much protection for innocent 
victims, but not enough. 

If Congress wants to act on behalf of the public, it should do so by strengthening 
protections for victims of fraud, toughening enforcement and deterrence to make fi- 
nancial swindlers and their accountants and lawyers think twice and three times 
before defrauding innocent people. 

I would respectfully suggest the following changes: 

• Treble damages in appropriate cases. As the Committee is well aware, the anti- 
trust laws of the United States provide for automatic treble damages, with attor- 
neys' fees and costs. Multiple damages are, obviously, a powerful weapon. In cases 
in which there is deliberate fraud by central participants, Congress should amend 
the law so as to provide a treble damage remedy. An appropriate treble damage 
remedy could further the purposes of both, deterrence ana compensation. 

• Non-removable state court jurisdiction. There are complaints in some quarters 
about the overburdening of Federal courts. Although securities class actions con- 
stitute but a small fraction of filings in the Federal courts, there is no reason why 
a state court should not exercise concurrent jurisdiction. Non-removable state 
court jurisdiction will allow the simultaneous pursuit of Federal and state claims 
in state court and would perhaps afford the victims a quicker remedy. 

• Increased discovery sanctions for defendants. There has been much talk about al- 
leged abuse by plaintiffs' lawyers. But, one often-omitted fact of class-action litiga- 
tion is that the defendants seek to exhaust the plaintiffs counsel by using motion 
practice and discovery as weapons in a war of attrition. In many cases, defend- 
ants' lawyers misuse the process to delay and complicate the litigation. Congress 
should consider increasing discovery sanctions. 

• Secrecy orders. In many cases, the defendants successfully seek secrecy orders at 
the outset of the litigation. For the most part, there is no genuine commercial or 
legitimate proprietary interest in secrecy. Rather, the defendant is seeking to pre- 
vent public disclosure of details of its own misconduct. This secrecy often runs 
counter to the public interest. Congress should pass legislation to limit secrecy or- 
ders. 

• Modified pleading requirements. It is simply a fact of life that investors in the 
public market will never have as much information as management insiders. Fre- 
quently, it is the case that massive insider selling precedes a stock plunge. Yet, 
in most jurisdictions, a plaintiff cannot survive a motion to dismiss even if he or 
she shows that such trading took place immediately before such a stock drop. 
Congress should consider adopting a mandatory rule that would allow further in- 
quiry in circumstances in which this type of selling exists. 

• The statute of limitations. Clearly, the one year/three year statute of limitations 
imposed by the Lampf decision is not sufficient. In some cases, a plaintiff has no 
reason to suspect fraud until years after the fraud has occurred. A three year/five 
year statute of limitations triggered by actual knowledge that fraud has been com- 
mitted (as is the case in many states) would better protect victims of fraud and 
let fewer wrongdoers off the hook. Any other standard (i.e., triggered if the plain- 
tiff "had reason to know" of the fraud) will only breed more litigation. 

Let me finish with one thought. I recently read that Senator Christopher Bond, 
a Member of this Subcommittee, was allegedly cheated out of $1 million and that 
he sued under the anti-fraud provisions of the Federal securities laws to recover his 
loss. I'm sorry Senator Bond lost his money. But I am happy he has a remedy to 



149 

pursue. Of course, with a $1 million claim and his status as a U.S. Senator, he is 
able to take his case to court on his own. I hope this Subcommittee will not move 
to curtail securities class-action suits, for they are the only means people more ordi- 
nary than U.S. Senators have to remedy their important — albeit smaller — losses. 



150 



-PVR 



PRINCETON VENTURE RESEARCH. INC. 



Exhibit 1 

June 15, 1993 



William S. Lerach, Esq. 

ivlilberg Weiss Bershad Specthrie & Lerach 

600 West Broadway 

1800 One America Plaza 

San Diego, California 91202-5050 

Dear Mr. Lerach: 

You have asked us to provide you with an analysis of Damages suffered by class 
members as compared to their Total Market Losses in Federal class actions involving 
violations of the Federal securities laws for publicly traded securities based on those 
litigations for which PVR has served as damage experts. 

PVR obtained a representative sample of these class action litigations as follows. First 
we obtained a list of securities law class actions that have settled and been reported in 
Securities Class Action Alert during 1992 and 1993. Second, we compared that list to 
those class actions where PVR were retained as damage experts. Third, we examined 
our files in Princeton to see for which of those litigations damage analyses and backup 
computer files were readily available. We found twenty such litigations. 

For each litigation we reintroduced the files onto our computer system and, using the 
same methodology for each litigation, we calculated Total Market Losses for all buyers 
and sellers of the stock during the Class Period. These Market Losses were then 
compared to Total Damages which had been prepared earlier to be used in testimony in 
these litigations. 

Damages usually differ from losses in that only that portion of Market Losses which are 
attributable to the alleged securities law violations are included in Damages. This is why 
a careful examination of the allegations in any litigation in the context of the principles 
of fundamental security analysis is necessary in order to determine Damages. You 
should also note that those litigations with long Class Periods tend to have both larger 
Damages and a smaller proportion of Damages to Total Market Losses. This is not 
uncommon as allegations of violations of the securities laws can be complex and vary 
over time for those litigations for which there is a long Class Period. Damages tend to 
increase as a percent of losses as one approaches the end of a Class Period and 
violations of securities laws become cumulative. 



Five Vaughn Drive. Princeton. New Jersey 08540 • 609-924-3000 



151 



-PVR- 



We conclude from this analysis that, on average, Damages in Securities litigation are 
27.7% of Market Losses. 

I believe that this analysis is based on a reasonable sample of securities law class action 
litigations and I am quite confident that the Damage analyses upon which these 
comparisons to Market Losses were based are sound - as they were prepared for expert 
testimony in the actual litigations. 

If I can provide any additional information, please do not hesitate to contact me. 



Sincerely, 




John B. Torkelsen, CFA 
President 



152 



PVR Analysis 

Securities Law Class Actions 

Damages as a Percent of Market Losses 



In Re: 



Class Period 



Total 
Losses 



Total 
Damaaes 



Damages as % 
Market Losses 



Shawmut National 


1 2/08/88 - 


- 01/24/91 


$442,407,875 


$34,91 1 ,880 


7.9% 


Lomas Financial 


04/20/87 - 


• 08/28/89 


$560,315,741 


$70,771,617 


1 2 6% 


Apple Computer 


11/29/82 - 


- 09/23/83 


$786,986,000 


$117,000,000 


14.9% 


Intermec Corporation 


01/23/90- 


- 06/21/90 


$41,749,338 


$12,819,200 


30.7% 


Beverly Enterprises 


04/10/87 - 


- 01/01/88 


$199,630,879 


$63,447,152 


31.8% 


Meridian Bancorp 


03/27/90 - 


- 09/26/90 


$32,135,663 


$12,331,038 


38.4% 


Raychem 


01/27/88 - 


- 01/12/89 


$273,260,973 


$115,408,280 


42 2% 


Fairfield Communities 


02/24/89 - 


- 06/20/90 


$17,387,548 


$7,978,163 


45.9% 


Hercules, Inc. 


03/06/89 - 


- 1/19/90 


$176,410,188 


$88,840,264 


50.4% 


First Service Bank 


1 2/05/86 - 


- 08/1 2/88 


$30,597,400 


$19,701,100 


64.4% 


Vicorp Restaurants 


12/14/89 - 


- 10/31/90 


$75,334,968 


$49,898,611 


66.2% 


Medical Imaging Centersl 0/25/90 - 


- 09/27/91 


$45,100,000 


$30,133,961 


66.8% 


Bell National 


09/30/82 - 


- 04/25/85 


$44,185,000 


$33,132,000 


75.0% 


OnLme Software 


08/26/87 - 


- 06/1 5/88 


$12,375,000 


$9,436,000 


76.3% 


Tonka 


09/07/89 - 


- 12/07/89 


$44,548,700 


$35,025,883 


78 6% 


AnnTaylor Corp. 


08/28/91 - 


- 10/21/91 


$29,861,170 


$23,770,613 


79.6% 


Nicolet 


05/15/91 ■ 


- 12/19/91 


$7,714,000 


$7,450,000 


96.6% 


ASK Computer 


02/28/85 - 


- 04/03/85 


$13,672,775 


$13,565,095 


99.2% 


Smith Corona 


07/28/89 - 


- 08/11/89 


$38,426,850 


$38,426,850 


100.0% 


Wolverine Technoloaies 03/12/88 ■ 


- 05/5/88 


$14622.188 


$14,622 188 


1 00.0% 


Total Dollar Losses 






$2,886,722,256 


$798,669,895 


27.7% 



153 



Returns to Victims in Securities Class Actions ExillUlt Z 

The legal terminology of class actions can be confusing. In order to make a 
mathematical calculation concerning the returns to victims of securities class actions, it is 
essential to understand that, in most cases where there is fraud, only a portion of those losses 
is due to fraud and only that portion of the loss is recoverable in damages. A Princeton Venture 
Research (PVR) study concludes that losses due to fraud (i.e. . recoverable damages) in securities 
class action cases, on average, are 27.7% of overall market losses. Other factors, such as 
market conditions, also contribute to investor losses. A good example of losses experienced due 
to market conditions was the stock market crash of October 1987. 

Combining the PVR average of 27.7% with other recent studies of market losses by 
victims and payments to victims in securities class actions reveals that victims ultimately receive 
59.78% of their legally recoverable damages on average, after payment of fees and expenses. 



To determine the percentage of legally recoverable damag es that class action settlements 
pay out, you must: 

(1) First, determine the percentage of overall market losses that are due to fraud (i.e. . 
the legally recoverable damag es). These vary over a wide range, but a PVR study of 20 recent 
settlements found an average of 27.7%. 

(2) Second, determine the total " out-of-pocket " or " market losses " that claimants 
experienced. 

The Heffler and Co. study of 69 cases found market losses of: $ 2,851,621,985 

The Gilardi and Co. study of 104 cases found market losses of: $ 7,746,522,800 

The Total Claimants' Market Losses for 173 cases is: $10,598,144,785 

(3) Third, determine the total legally recoverable damag es 
by multiplying the total out of market losses 

($10,598,144,785) by the percentage due to fraud (27.7%) $2,935,686,104 

(4) Fourth, determine the total amounts paid to claimants. 

The Gilardi and Co. study found $1,446,482,548 

The Heffler and Co. study found $ 308.438.656 

Total Funds Paid to Claimants $1,754,921,204 

(5) Finally, determine the ratio of the total of payments to 
claimants to legally recoverable damages , after payment of fees 
and expenses 

$1.754.921.204 
divided by $2,935,686,104 = 59.78% 



154 

Exhibit 3 

Percente2e of Attorneys Fees in Class Actions 

A Study Prepared by Class Action Reports 
(Involving 404 Cases from 1973 - 1990) 



Recovery 
Range 

($ 
millions) 


No. of 
Cases 


Aggregate 
Class 

Recovery 
($ millions) 


Fees 

* 
Costs as % 


Atty 
Hrs. 


Multiplier 


Current 

Hourly 

Rate 

(la 10/90 $) 


ZSSQm 


12(12)* 


2,299 046 


8.2 


336343 


1.78 


463.59 


Antitrust 


11(7) 


1.485.816 


13.0 


464.158 


256 


40961 


S20<S50m 


22(20) 


692.246 


17.8 


266,400 


2.45 


464.76 


Antitrust 


9(6) 


257.250 


14 1 


//6.5>69 


7.74 


279/J 


S10<S20m 


41 (34) 


574.795 


25.9 


364,061 


1.75 


353.95 


Antitrust 


9(7) 


130259 


13.0 


74.654 


1.47 


295.75 


S5<S10m 


49(43) 


335.023 


25.8 


277,230 


1.53 


319.90 


Antitrust 


16(15) 


109364 


222 


101573 


2.01 


306.31 


S3<S5m 


52(48) 


202.682 


28.6 


214,191 


1.55 


303.22 


Antitrust 


9(8) 


35 152 


2J.7 


29824 


7.74 


308.49 


52<S3m 


31(25) 


72.413 


25.2 


65,165 


1.33 


291.60 


Antitrust 


6(5) 


14558 


21.1 


18.930 


1.45 


197.80 


Sl<S2m 


48 (37) 


65.664 


28.3 


83,702 


1.14 


227.60 


Antitrust 


4(3) 


6.863 


2*.S 


; 1.674 


1.11 


171.48 


<Slm 


79 (64) 


39.494 


27.2 


84,550 


0.89 


170.52 


Antitrust 


6(5) 


2.0J2 


34.2 


6^75 


1.12 


174.78 


Securities 


334 (283) 


4,281.362 


15.2 


1,691.642 


1.72 


363.38 


Antitrust 


70 (56) 


2,041.295 


;j.« 


824,000 


2.17 


354.19 



'Numbers in parentheses refer to cases far which there are hourly data. 



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163 

PREPARED STATEMENT OF GORDON AND ELIZABETH BILLJPP 

My name is Gordon Billipp and I live in Jaffrey, New Hampshire. I graduated 
from Columbia College in 1943 with a degree in business administration. Served as 
naval officer in the Pacific in World War II. After the war, I corked for the Arm- 
strong Cork Company (now Armstrong World Industries) for twenty-four years. Re- 
signed in 1969 and moved to New Hampshire where I bought a metal stamping 
business. Operated it to 1982, sold it and retired. 

My wife, Betty, attended Wilson College in Chambersburg, Pennsylvania on a full 
scholarship. Class of 1946, and majored m English. 

After raising our four sons, she worked in real estate for twelve years until she 
too retired. Has just completed years of service on the Board of Directors of a retire- 
ment home and a non-profit community day care center both in Peterborough, New 
Hampshire. 

I was a Director of Vermont-New Hampshire Blue Cross/Blue Shield and am serv- 
ing my twenty-second year on the Board of Directors of the Granite Bank of Keene 
and its predecessor. 

Our educational and work backgrounds have been listed because we have worked 
hard for ourselves, our family and our community. We are here today because we 
believe that, while our legal system may not be perfect, it has worked to provide 
us with some recovery of losses caused by civil crimes committed against us and 
many others. 

In 1985, we purchased bonds in a retirement home venture that we felt was a 
good investment, both for ourselves and for an industry that serves the largest cat- 
egory of citizens in the United States, the elderly. 

In all, $16 million of Spartanburg, South Carolina revenue bonds were sold to con- 
struct and operate a privately-operated retirement center there. We bought $20,000 
of the Bonds. 

However, due to the fraudulent activities of the promoters and the so-called legal, 
accounting and broker professionals involved, our investment became worthless 
within months of the opening of the center. 

After looking into the cause of the failure we learned for the first time that the 
developer, Mr. C.D. Stone, was a convicted felon and that he and the accounting 
firm had worked together on other retirement home bond deals, almost all of which 
had failed. 

We also learned that the underwriter, Bob Buchanan of Buchanan and Company 
of Jackson, Mississippi, had sold most of the bonds by sponsoring free lunches in 
retirement homes in Arizona and Florida and by falsely representing to the resi- 
dents of those homes that the bonds were ninety-nine percent safe — and as safe as 
U.S. Treasury bonds. I have attached a copy of a Forbes magazine article describing 
Mr. Buchanan's unscrupulous sales tactics. 

Litigation was our only hope of recovering any portion of our money. We filed a 
class-action lawsuit on behalf of ourselves and almost 2,000 others to recover the 
bondholders' lost investment. The litigation was slowed down only by obstacles engi- 
neered by the defendants, most of whom were represented by insurance companies. 

The insurance companies hired lawyers who seemed to subscribe to a theory that 
they best way to represent a client is not to address the merits of the litigation, 
but to overload the plaintiffs' attorneys with extraneous briefs and motions, Dy de- 
manding our tax returns, requesting particulars on our income and our investment 
history and practices. Their purpose was, I am sure, to either dissuade us from con- 
tinuing with the lawsuit or to find something that said that we were "sophisticated" 
investors and should have known that the defendants were out to steal our money. 
In other words, that we the victims were to blame for our misfortune. 

Eventually, most of the insurance companies' lawyers decided to settle the case. 
A large portion of the settlement funds came from the accounting firm defendants, 
who started out with a five million dollar policy ($5,000,000) but could pay only 
about $750,000 to settle the case because their lawyers' fees and prior settlements 
had used up the original coverage. 

When all was said and done, the bondholders recovered about $10 million out of 
the $16 million they had invested. Although we did not recover all of our invest- 
ment, we were also partly vindicated by the criminal convictions of Mr. Stone, Mr. 
Buchanan and two others involved in the project. We are glad that we received some 
remuneration and feel that our efforts may have helped to end the careers of a num- 
ber of fraudulent operators. 

Maybe there are things that need to be fixed in our legal system. But, as voters, 
taxpayers, and insurance customers and victims of fraud we ask that you not make 
it more difficult for people like us to initiate suits to recover losses caused by fraud. 
If the law had required Betty and me, other bondholders or our lawyers to pay the 



164 

defendants' exorbitant legal fees if we were to lose the case, we never would have 
stuck our necks out to represent the 2,000 investors, many of whom had invested 
the savings of a lifetime. 

I know that frivolous litigation is sometimes filed. But I also know that requiring 
the plaintiff in a securities class action (whose personal investment may have been 
small) to assume the risk of paying many times that amount to the other side's law- 
yers, will discourage the filing of as many meritorious suits as frivolous ones. 

Had we not filed this suit, I believe the bondholders would have recovered very 
little of their investment and Messrs. Stone and Buchanan would still be on the 
street selling more junk municipal bonds, instead of serving time in prison. 

I am told that there are criticisms leveled at the age-old principle of ioint-and- 
several liability. But if an accounting firm, lawyer or other professional willingly as- 
sociates himself or herself with an unscrupulous developer, they should have to pay 
the full price for the consequences of that relationship. No one is forced to sell secu- 
rities to the public. If they don't want to assume the responsibilities imposed by law 
for entering the public securities market, they should borrow the money from a 
bank instead of selling bonds to individual investors. 



165 



Forbes 



Congress gave a tax break to developers of 
retirement communities. Some break. It 
leaves senior citizens in bankrupt retire- 
ment homes and has cost bond buyers 
around a half billion dollars in losses. 

An expensive 
free lunch 



By Matthew Schifrin 



Retired Akmy Colonel Thomas 
Miller well remembers the day 
he attended a free-lunch in- 
vestment seminar at Tucson's OK 
Corral. After dining on steak and po- 
tatoes, the 72-year-old Miller and 
about two dozen other gray-haired se- 
niors listened to a pitch on tax-free 



investing in the retirement industry. 
The seminar's sponsor: Buchanan & 
Co. of lackson, Miss. 

"They were very smooth," says 
Miller. 'They told us that municipal 
bonds were 99% safe." Three years 
and five lunches later, Miller has al- 
ready lost 566,500 of the $131,000 he 
invested in bonds secured by nonprof- 
it retirement communities. 




I'mxm ivtint*. (jiluiivl TfoimilS mill Mtny Milhr 
Their/ree lunches have cost them $66,500 so Jar. 



And not only bondholders .ire being 
elicited. One of Miller's delauhcd 
bonds is for the 240-unit Skvlyn Hall 
retirement center in Spartanburg, S.C. 
lust a few days before Skylyn's bank- 
ers foreclosed, Julia Manning paid 
S34.000 for a Skylyn unit. At 93, Man- 
ning requires a companion to help her 
get by from day to day Adding to her 
worries, Skylyn's promised on-prcm- 
iscs nursing home may never open. 

Manning and Miller arc only two 
among tens of thousands of victims of 
a billion-dollar tax-exempt bond scan- 
dal. II you haven't heard of this scan- 
dal, it's because there's no sure way of 
tracking the issuers or the victims, 
since these elderly-housing issues are 
exempt from SEC registration. Con- 
gress accorded them that dubious ex- 
emption by allowing them to be treat- 
ed as "municipal" bonds. This much 
is now clear: Over SI billion in de- 
faulted retirement facility and nurs- 
ing home bonds have already cost un- 
wary investors hundreds of millions 
of dollars. 

No underwriter has been more ag- 
gressive in this game than Buchanan 
&. Co. of Jackson. Over the last five 
years this obscure brokerage has un- 
derwritten some S600 million worth 
of tax-exempt retirement center and 
nursing home bonds. Of the estimat- 
ed S5 billion worth of such bonds 
marketed nationwide in the last ten 
years, over SI billion worth, raised in 
100 issues, has gone into default. 
About half of the 100 defaulted issues 
were marketed by Buchanan &. Co. 

Congress has closed the door on 
most other tax-free revenue bonds lor 
subicctcd them to state-by-statc ceil- 
mgsl. With brokers thus gasping lor 
product to peddle, tax-exempt financ- 
ing lor retirement facilities has been 
jitracung such big-time underwriters 
as Smith Barney and Morgan Stanley 
Hut ihcy have been iclaiively small 
players. Buchanan has been one ol ihc 
biggest plavcrs, llooding the market 
wuh lax-exempt paper with little ic- 
g.ird to the quality ol the pioiccts se- 
cured by the bonds. During the late 
1970s and early l9S0s Buchanan did a 
successful business in underwriting 
tax-exempt bonds lor utility distuets 
and nursing homes Why mil transler 
i his success io I be linancingolfered in 
retirement home pioiccts- Buchanan 
plowed ahead. 

[■'hi Buchanan, which already had 
ollices set up in Tampa, Tucson and 



rORUlS lANUARY IS. IVSK 



166 



iithci Sunbcli cmcs, maikciiiiK the 
bonds proved ;i snap, l-<>r laiKCl inves- 
tors, i he lnm aimed .u senior citizens, 
wlui, .liter .ill, would naturally he 
sympathetic to the purpose ol the 
proieets |As 3 rule, however, inves- 
tors were not also residents. I At the 
lunch seminars, bondholders claim, 
salesmen would routinely suggest 
that retirement centers were just like 
nursing homes and that municipal 
bonds were as good as money in the 
bank. Buchanan advertised iuicy tax- 
free rates— 12% to 16% — on (irst 
mortgage bonds. To attract developers 
and proieets to finance, Buchanan ad- 
vertised 100% financing in health in- 
dustry trade magazines. 

The brains of the operation was — 
and is — Robert Buchanan Jr., 51, a 
penny-pinching onetime pharmacist 
and son of a Mississippi preacher. 
Known as a taskmaster who, former 
employees say, goes out ot his way to 
check the return slots of pay tele- 
phones lor uncollected coins, Buchan- 
an personally does much of the dig- 
ging that turns up promotablc prot- 
ects. He declined to be interviewed for 
this story, clearly preferring to keep a 
low profile. 

What buyers of the bonds did not 
always realize, however, is that — as 
with other private-purpose revenue 
bonds — the nominal issuer, a munici- 
pality, is not in fact the borrower. 
These are not full faith and credit 




. titiixuiail & Co •* KalKri titidxiiuiii /r. 
Keeping a low profile in Jackson. 

bonds. The municipality simply lends 
its tax-exempt status to a special, 
nonprofit entity created to own and 
run the project once it is built. So 
even though bond prospectuses bran- 
dish names like New |erscy Economic 
Development Authority and the 
Mesa, Ariz. Industrial Development 
Authority, the entity backing the 
bonds is actually the poorly capital- 
ized nonprofit entity. 
No surprise that the S5.S million 



retirement village in Bowling Given. 
Kv , .i Buchanan bond issue th.u came 
out in 19X3, is trading .it about 10 
(.cms on the dollar alter defaulting in 
l n SJ Hunt's Healthcare, .in Indiana 
nursing home Buchanan underwrote 
in IVKS, is going (or 75 cents, even 
though it is still paying interest— out 
of its reserve fund, however. 

"These arc the penny stocks ol the 
bond business," says Richard Lch- 
mann, whose Miami-based Bond In- 
vestors Association tracks defaults of 
both muni and taxable bonds. Most of 
the retirement home issues arc unrat- 
ed by Moody's or S&.P, and like all 
municipals they arc not registered 
with any state or federal regulatory 
agency. 

Thus unrated and unregistered, the 
bonds could not be easily sold to well- 
■ intormed investors. Which is why Bu- 
chanan went out and beat the bushes 
for relatively unsophisticated inves- 
tors tempted by high yields. 

One reason so many of Buchanan's 
proieets flop is that the sites arc hasti- 
ly chosen and arc often totally inap- 
propriate locations for retirement 
homes. Take the Edwinola retirement 
center, a 255-unit, Buchanan-financed 
project located smack in the center of 
run-down Dade City, Fla., 30 miles 
north of Tampa. Four months alter 
opening in late 1983 the proicct filed 
for bankruptcy, having attracted few- 
er than 15 residents. 



The ten worst 


Apart from the $2.25 billion WPPSS bankruptcy, the Si the worst muni bond disaster in history. Below, the ten 
billion in defaulted retirement facility bonds stands as biggest underwriters of these issues. 


Underwriter 




Defaults 
(Smill 


Nuntber ol 
projects 


Comment 


Buchanan &. Co. 
lackson, MS 




S3v0t 


31 




Free lunch seminars corralled some $600 million ol bond buyers. Most feasibility 
studies Horn Mav Znna c* Co 


Ilereth, Orr tt Jones* 

Atlanta, GA 




270t 


10 




After several defaults ul bonds it underwrote, was shut down late 1983 lur net capital 
violations Feasibility firms include Laventhul N Horwath. Price Waterltouse 


Swmk & Co. 
Utile Rock, AR 




I0M*. 


7 




Aiter retirement protects in 4 states defaulted, still very active in >unk mums 
Feasibility hrms include Lavcnthol, Mav Zima 


Henderson Few b. Co. 
Atlanta, GA 




106* 


A 




Founder Gerry Henderson moved from Atlanta tu Sarasota, Fla. Now active in 
retirement center workouts. 


Miller &. Schroeder 
Minneapolis, MN 




97t 


a 




Placed many of its hoods in insured unit trusts feasibility firm Laventhol 


J. .Mi lion Newton 4. Co 
St. Petersburg, ft 


.- 


54 


J 




Founder I Milton Newton taught RuOeri Buchanan It the business Alier 
(manual reversals in iyH4. Newton committed suicide in office. 


(urart i. Moody 
St. Paul, MN 




36 


■y 




Successful in utility district bonds, encountered prohlcms in retirement centers 


III v € h Fastnian PaitteWebher 
New York. NY 


lit 


1 




IX-laulted retirement home bonds settled in IVS5 lot VI cents on the dollar 


Herbert |. Sinuns 
Xrr* York. NY 




3Jf 


1 




Only default ol the dozens ol tetifemeot CCllltn* it has under win ten Pelault settled 

in ly>»*i Iset lUvih Eastman) 


| Merrill Lvnch 

j New York, NY 




32* 


I 




Failed Westminster Village in Daphne. Ala refinanced iwkc, nuwwt% 
uccupied Meinll l.vnch made eu.id the losses til iinftmal bo dholJcfS 


1 **••> :■ Mii;cr iii ImimiH-v« 


Hull .Mil 


MMN Ul-UtMAl Ul m- 


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... 


•!mluoV> pan* i|».io.io io icIUiik >miUh.iic ul ISJ ihiIImmi Knval Kvyvius pforeil 

s """« /trvit/ fi»tVi«) AwKkMNM litiitk fiiuttvy lAwkr* /nw? 



167 



In short, some piutccts were Inn It 
more as nil excuse (at issuing bonds 
th.in nn the h;isis ol sound studies 

In some cases, construction costs 
were allowed to escalate mil of con- 
trol. In one sued protect, the I'ataskal.i 
Country Manor in Licking County, 
Ohio, Buchanan raised S2.3 nullum 
through a 1985 tax-exempt hond is- 
sue. But all the money was gone be- 
fore construction was completed. 

In virtually all the cases, Buchanan 
and its partners routinely skimmed 
off so much money in upfront under- 
writing and related fees that there was 
little left to execute the project itself. 

Take Buchanan's Sun Mesa Health 
Care Protect outside Phoenix, Ariz. 
Less than S9 million of the original 
SI 5.5 million bond issue in 1984 was 
allotted for land and construction. 
Most of the rest was committed to 
fees, including more than SI. 6 mil- 
lion, or 10%, to Buchanan itself. Ac- 
cording to the prospectus, around 
$500,000 in fees was for marketing 
the units. But marketing was legally 
impossible — since the promotors nev- 
er got the necessary state permit. 

The now-defunct Atlanta office of 
May Zima fit Co., a firm listed on 
dozens of failed retirement protects, 
came up with Sun Mesa's rosy feasi- 
bility study. According to May Zima's 
assumptions. Sun Mesa, which never 
opened, would be up to 90% occupied 
within three years of the bond issue. 
At the time, there were 3,254 units in 
other retirement homes already oper- 
ating in the area and another 725 
units under construction. All this was 
routinely mentioned in the prospec- 
tus, but most of Buchanan's bond buy- 
ers weren't the kind who read pro- 
spectuses. 

Not satisfied with fat fees, Buchan- 
an & Co. has found a way to profit 
from its failures by speculating in the 
defaulted issues. When protects fail, 
Buchanan's brokers, as markct- 
makcrs, can buy back the bankrupt 
bonds at 20 cents to 40 cents on the 
dollar. At the same tunc Buchanan 
sometimes brings in a workout team 
to help revive the protect. 

Buchanan has had company in re- 
tirement underwriting Merrill Lynch 
underwrote a S32 million, 292-unit 
Alabama retirement center that went 
bust nearly three years alter the bonds 
were issued. To its credit, Merrill 
Lynch made good the losses. Hut less 
than I0°«. (it the defaulted protects 
have been underwritten by major 
(inns The primary peddlers <>l these 
unrated high-yielding tax exempts are 
regionally based muni dcalcis — like 
Buchanan — clearly unable and un- 
willing to make investors whole. 



Buchanan ^ Co is lacing at ...isi 
six lawsuits in lour stales A i.ouil 
victory lor investors could be ho.i.iw, 
however. Last year the linn lost >2 S 
million, according to the Mississippi 
securities commissioner, and as ol 



in capital, lis a lesson thai investors 
keep learning over again ilic liaid wav. 
Bonds iii.it p.iv way above niaike: in- 
iciest i.nes may be no baigain Ami 
lust because .something has a tax hen- 
cl it doesn't mean that it's a good 



October IVN7 was down in .>4ls.'XH) investment ■ 

Spend more, the U.S. urges Japan. 'The Jap- 
anese are responding, but in ways that do 
the U.S. little good. They are gorging on 
gold, diamonds, jewehy. 

Enjoy! Enjoy! 



By Andrew Tamer 



T|adaiiiko Fukami recalls with 
relish when the Tokyo stock 
market tested new heights last 
August. Waves of wealthy customers 
swarmed to his Yamazaki Co. stores, 
where many of them plopped down 
million-yen bundles of notes wrapped 
in the paper of Japanese securities 
companies. 

Having sold stocks, what were they 
buying? Cold, platinum, diamonds 
and other precious metals and jewelry 
pieces. Annual sales at Fukami's Ya- 
mazaki have doubled (in yen terms) in 



five years, to S230 million. "People 
have become rich here," explains Fu- 
kami. "But they can't afford in buy 
land or houses, so they're buying jew- 
elry instead." 

lapan is entering a golden age. After 
sweating and sacrificing to rebuild 
their economy and supply themselves 
with modern life's basics, middle- 
class lapancsc arc now beginning to 
indulge themselves in life's luxuries, 
from mink coats and BMWs to pre- 
cious metals and jewelry. 

To catch some of the spending, 
trading companies such as Sumitomo 
Corp., (apan's biggest gold dealer, arc 




Sllllltlallltl (.t/tf N ;\k'ttl Imttnlltl tt 

"The government wcu loo confident. " 



rORHt.S. lANI'APY 25. 1VK8 



168 

PREPARED STATEMENT OF RUSSELL E. RAMSER 

I like a good lawyer joke just like everybody else. But when I see who it is that 
wants to "reform" our judicial system, I know that something is wrong with the pic- 
ture. 

From 1985 through 1989, I bought over $100,000 worth of municipal bonds to fi- 
nance the operation of nursing homes in Terre Haute, Indiana, Sullivan, Illinois, 
South Beloit, Illinois, Effingham, Illinois, Forsyth, Illinois, Atlanta, Illinois, ana 
Franklin Grove, Illinois. The issuer of all these bonds was First Humanics Corpora- 
tion, which was represented to be a Christian organization devoted to caring for sen- 
ior citizens. I bought the bonds because I needed the regular, supposedly safe, in- 
come for my retirement, and I liked the fact that my money would be put to a good 
use. 

What neither I, nor the 4,000 other bond investors knew, was that the money we 
were paying for our bonds was not being used to fix up and operate the nursing 
homes as had been represented to us; it was being used to buy the developer, Lee 
Sutliffe, a yacht in Fort Meyers, Florida. We didn't know and weren't told that Mr. 
Sutliffe was a con artist who had been caught impersonating a bond lawyer for a 
number of years. We didn't know and weren't told that Mr. Sutliffe had been con- 
victed of cheating on his taxes. We didn't know and weren't told that the man he 
hired to run his nursing homes had been run out of the State of Florida for provid- 
ing substandard care to his nursing home residents there. And although we were 
given a long list of other nursing home projects that Mr. Sutliffe had developed, we 
weren't told that every one of those projects was a failure. 

I believed what I was told in the prospectuses because they were prepared by law- 
yers who were supposed to be experts in the field, and the feasibility studies were 
prepared by the international public accounting firms of Deloitte & Touche and 
Price Waterhouse. I never would have imagined that these so-called professionals 
would do business with a man like Lee Sutliffe had they known of his past — but 
they did. 

In 1989, all of Sutliffe's nursing homes bankrupted simultaneously. That came as 
a shock because we had been told in the prospectuses that each bond issue stood 
on its own. If one nursing home failed, it would not affect the other homes developed 
by Sutliffe. The truth is that the homes were being operated by Sutliffe as a Ponzi 
scheme, and the money being raised in each bond issue was being used to pay his 
personal debts and to pay debts at other nursing homes. Sutliffe was robbing Peter 
to pay Paul. 

A bondholders' committee was formed in the bankruptcy, and I volunteered to 
serve. I was surprised to find out that the SEC has no oversight over the municipal 
bond markets. People like Lee Sutliffe do not have to have the SEC's permission 
to sell municipal bonds. The only recourse we had was to file a lawsuit. 

When our lawyer filed the suit, the army of defense lawyers (who were paid by 
the hour) began to attack not only our positions on the merits of the case, but my- 
self and my family. They accused us of filing frivolous litigation, and tried to talk 
the judge into awarding sanctions against us. They tried to get the judge to dis- 
qualify our lawyers from representing us. Their investigators tried to dig up every 
little piece of dirt they could find on the bondholders and on our lawyers in an effort 
to scare us into dropping the suit. It didn't work. 

A few months after we filed the suit, the Supreme Court handed down a decision 
that shortened our statute of limitations. Relying on the old limitations period, our 
lawyers had taken three or four months to carefully investigate the merits of the 
case before filing a lawsuit. But as a result of that Supreme Court decision, our case 
was dismissed. If our lawyers had not been so careful, the case would have been 
timely. I wrote letters to several Members of this Subcommittee asking you to sup- 
port legislation to overturn the retroactive effect of that Supreme Court decision, 
and thankfully, you did so. After that act was passed, we asked the judge to rein- 
state our case, but the accounting firms didn't care what the Congress had said. 
They argued that your legislation was unconstitutional. The judge saw through 
their bluster, and sent our case to a jury. 

In February of last year, we were allowed to try the liability of Sutliffe and 
Deloitte & Touche in a Cincinnati Federal court. Deloitte & Touche never offered 
one cent to settle the case before trial. But after an eight-week trial, a jury of nine 
Ohio citizens found Deloitte & Touche and Lee Sutliffe guilty of racketeering, Fed- 
eral securities violations and fraud. The jury found that Deloitte & Touche knew 
about Sutliffe's past, and knew that the nursing homes were being operated as a 
Ponzi scheme, and conspired with Sutliffe to hide those facts from the public. 
Deloitte & Touche paid us $15 million to settle the case, and Price Waterhouse, 



169 

after seeing what a jury of Ohio citizens thought of Deloitte & Touche, paid us an- 
other $11,800,000. Sutliffe eventually pleaded guilty to securities fraud. 

All together, our lawyers recovered over $46 million for the bondholders. Even 
after paying attorneys fees, the bondholders as a whole received approximately 50 
percent of their losses. Plus, our bondholders' committee hired new management to 
run the nursing homes, and most of the homes now are able to pay their bills and 
are paying some of the interest on the bonds. 

I know that it is fashionable in some circles to criticize our judicial system. But 
in my case, the system worked. The judge saw through the defendants' attempts to 
confuse the issues, stopped most of their attempts at harassment, and overruled 
their efforts to get him to ignore your legislation. I understand that there is a big 
push going on to reform our litigation system, including a new "loser pays" rule, and 
no more joint and several liability. If either of those "reforms" had been the law two 

Sears ago, our case would never have been filed, and the bondholders would be 
ankrupt along with Mr. Sutliffe. My lawyers told me when we filed the case that 
we probably would have to take it all the way through trial, so I knew that we were 
gambling my time for the next two years, and a great deal of expense money, on 
what a jury would say about the accounting firms' conduct. Although I was com- 
fortable in my belief that the bondholders had been wronged by the accounting 
firms, I would not have filed the suit if, in addition to devoting my time to the case, 
I would have been required to pay their millions of dollars of attorney fees in the 
event that the jury, or a judge, did not agree with me. 

Likewise, without joint and several li ability, instead of being made almost whole, 
the bondholders in my case would have received virtually nothing. The issuer of the 
bonds, First Humanics Corporation, was described to us as a religious organization 
devoted to caring for senior citizens, but was actually a shell corporation that 
Sutliffe set up as a tax-exempt organization with Deloitte & Touche's assistance so 
that he could sell municipal bonds. It had no assets and was in bankruptcy. Swink 
& Co., the primary underwriter of the bonds, was bankrupt and Mr. Swink was 
being investigated for another securities fraud (I am told that he has been con- 
victed). Although Mr. Sutliffe was living on a yacht in Florida, we knew that he had 
taken several trips to the Bahamas and we doubted that we would ever recover any- 
thing of any significance from him. Our only hope of recovery was from the account- 
ants and lawyers, without whose help Sutliffe could never have sold the bonds. 

I don't think that accountants should be given any special treatment. Sutliffe 
could never have sold his junk municipal bonds without the instant credibility of 
having Deloitte & Touche and Price Waterhouse's names on the cover of his 
prospectuses. They knew about his problem past (and present), and were fully 
aware of their responsibilities under the securities laws. Nevertheless, they volun- 
tarily took a gamble on Sutliffe and sold their name for a lot of money in order to 
give Sutliffe the credibility he needed to sell his bonds. Nobody twisted their arms 
and forced them to do business with Lee Sutliffe. 

Like I said, I can bash lawyers with the best of them. But I think that much of 
the lawyer bashing I hear is being pointed in the wrong direction. I can tell you 
from first-hand experience that the delays in our case were not caused by the plain- 
tiffs' lawyers, who only get paid after the case is over. The delays were caused by 
the defense-lawyers who were paid by the hour to try to distract the judge from the 
merits of the case and to try to harass the plaintiffs into dropping their case. Please 
be careful not to pass legislation in the name of "reform" that really is designed to 
avoid responsibility for actual wrongs. 

One more thing. Please do not forget that securities fraud does not just hurt Wall 
Street speculators. Through my position on the bondholders' committee, I saw many 
a tear on the face of retirees who lost their life savings on what they thought were 
safe investments — municipal bonds. And please don't forget the senior citizens who 
were living in these nursing homes. Because Sutliffe and the accountants raked off 
so much money in up-front fees, not only were the nursing homes unable to pay the 
interest on the bonds, they were unable to take proper care of the senior citizens 
who were in their care. At trial, I saw and heard evidence that in some of the Illi- 
nois homes there was so little money available for patient care that patients were 
not moved from their beds and had bed sores so extensive that the bed sheets had 
to be cut away. One man was found to have gangrene in his foot so severe that 
maggots could be seen in the wounds. One elderly man was permitted to wander 
off the premises and died of hypothermia. 

Please don't forget these innocent senior citizens, who through no fault of their 
own, are neglected and abused because some big accounting firm or Wall Street out- 
fit was more interested in a quick buck. 



170 



Thorn Apple Valley 

Thorn Apple had anv stability. It 
would show earnings of S7 million 
one year and lose $5 million in anoth- 
er, depending on the hog cycle. 

Joel Dorfman knew that he would 
never get the kind of price he wanted 
on his stock so long as the earnings 
were so unpredictable. The stock was 
at 3 in 1987, versus its IPO price of 16. 
He saw a way out: He proposed tight- 
ening management structure, design- 
ing a marketing plan and setting up a 
central distribution warehouse in 
Michigan. 

But dad said no. He didn't want to 
let go of the company he had found- 
ed. Joel Dorfman suggested taking 
the company private in a leveraged 
buyout. Henry couldn't see taking on 
die necessary debt, so he again said 
no. Thorn's big compedtor. Smith- 
field Foods, Inc. (Forbes, Feb. 3), 
offered S10 per share for the compa- 
ny. This dme both Dorfmans said no. 

But Joel was getting fed up. Dad 
knew it. In 1988 he reluctandy 
stepped aside. Joel took over and 
adopted a new nadonal sales and mar- 
keting plan that emphasized high- 
margin, premium branded products. 
Responding to industry trends to- 
ward leaner products, he increased 
the use of poultry , especially turkey, in 
processed meat, and expanded the 
product line. Drawing on his knowl- 
edge of the hog kill, Dorfman rede- 
signed Thorn Apple Valley's hog 
slaughtering faciliucs in Detroit and 
Utah to give each employee more 
room and time to work. Production 
yields, the amount of salable meat 
removed from the hog, increased 
from 56% in 1989 to a "recent 59%. 
Even' 1% improvement in yield in- 
creases Thorn Apple Valley's revenues 
by S6 million. 

Today old Henry Dorfman doesn't 
regret stepping aside. In fiscal 1991 
Thorn Apple Valley earned over S19 
million on revenues of S817 mil- 
lion — S4.43 ashare. In 1992 earnings 
gamed 8%, although revenues fell 9%. 
While the stock is up more than ten- 
fold in the three years since he took 
over, it rankles Joel Dorfman that his 
r/F lags so far behind those of com- 
petitors (sec tabic, p. 78). Dad, howev- 
er, isn't taking any chances. Last De- 
cember the elder Dorfman cashed in 
500,000 Thorn Apple Valley shares at 
around S33 a share an 



Here's what can happen to nice investors 
who think they are safe just because a Big Six 
accounting firm is involved. 

Reach for 



the sky! 



By Richard L. Stern 




Lee Suthrfe and girlfriend Carol Zandio 

They're smiling, but the bondholders are not. 



In 1987 the Illinois Department of 
Public Health reported shocking con- 
ditions at some of the nursing homes 
owned and operated by First Human- 
ics Corp. Among other things, in- 
spectors found untended elderly pa- 
tients tied to wheelchairs for hours at 
a time. Daily food budgets at some of 
the homes were cut to as low as S2.1 5 
per day per patient. 

In the end. First Humanics didn't 
treat its public investors anv better 
StartinginM.iv 1989, First Humanics 
stopped nuking interest payments on 
the 21 tax-exempt revenue bonds it 
had sold separately, many of them io 
unsuspecting amateurs looking for 
high yield, from 1984 to 1987." 



First Humanics had used the mon- 
ey to buy 17 nursing homes and a 
retirement center in Illinois and 3 
nursing homes in Indiana, Michigan 
and Pennsylvania. In September 1989 
First Humanics filed for Chapter 1 1 
bankruptcv protection. 

Badlv burned were about 4,000 
bondholders who wish thev had never 
heard of Lee Sutliffe, the promoter 
behind First Humanics and the nun 
to whom (hey had entrusted more 
than SS2 million. 

Of the SS2 million raised, Sutiirt'e 
spent onlv S54 million to purchase 
nursing homes What happened to 
the other S28 million? 

Quite a hit of it was spent sprucing 



Hirst Hum antes 



171 



up the acquired homes instead of 
making necessary structural improve- 
ments. Sutlirie's girlfriend, Carol 
Zandlo, is an intcnor decorator; she- 
spent hcavilv on drapes and furnish- 
ings for the facilities. 

Millions more were paid in fees to 
help make First Humanics' bonds sal- 
able. Optimistic financial forecasts 
were prepared by r*o of the nation's 
largest accounting firms — Touche 
Ross & Co. (now known as Deloitte 
& Touche) and Pncc Waterhousc — 
and reviewed by investment bankers. 

Sutliffc and Zandlo also pocketed 



hirst Humanics' paper. 

In the laic Seventies Sutliffc 
worked as a lawyer in Colorado for a 
nursing home operator. That job 
ended when his emplovcr learned 
Sutliffc wasn't a lawyer. 

In 1985 the state of Missouri issued 
a cease-and-desist order against Sut- 
liffe for securities registration viola- 
tions and false filings in connection 
with oil and gas deals. 

Why did investors put their money 
in First Humanics? Virruaily nothing 
was revealed about Sutliffe's history 
or the fact diat seven of his prior bond 




Bondholder committee chairman and ex-lighter pilot William Ayers 
He s successfully put First Humanics in his sights. 



nearly S2 million in development and 
decorating fees Court papers alleee 
that Sutliffc took at least one kickback 
from a real estate agent and got a 
S250,000 personal loan from the sell 
cr of a nursing home Sutliffc took in 
• an estimated S2.5 million more buv- 
ing some of the homes himself, and 
then selling them to First Humanics. 
In 1975 Sutlilfc pleaded no contest to 
an Internal Revenue Service charcc of 
criminal failure to file income tax 
returns. Sutlitl'e allegedly paid pan of 
the overdue ta\ with monev from one 
of the bond offerings. 

Is Sutlilfc in jail: .-Mas, no. A tan 64- 
year-old fellow . he currently lives with 
Zaiulloon a\aclu in Florida. Had the 
unrortunaic bond buvers known 
about Sutliffe's background, they 
might have been less tempted to bus- 



deals were going bad, or that the 
earlier First Humanics deals were al 
ready failing. If tax-exempt securities 
were subject to the scrutiny the Secu 
nties &c Exchange Commission gives 
corporate issues, at least some of this 
would probablv have been disclosed 
But in the unregulated tax-exempt 
market, due diligence and disclosure 
too often arc minimal. 

To the extent that investors were 
reassured by the high quality of the 
firms doing forecasts lor First Hu 
manics, they were badlv let down. 

Sutliffc and Zandlo might have 
vachtcd into the sunset but lor one ot 
their shafted bondholders: William 
Avers, a 5 1 year old retired Air Force 
tighter pilot who owned S2 million 
worth ot Sutlitfe's paper. In 19°(l 
Avers became head of a bondholders' 



committee thai, through the bank- 
ruptcy courts, eventually took control 
ol the nursing homes and sued the 
professionals and principals that were 
involved in First Humanics. 

Avers had good reason to be mad. 
Touche Ross had conducted the feasi- 
bility studies on Sutliffe's first 1 2 First 
Humanics issues. Another Big Six 
accounting firm, Pncc Waterhousc 
did the feasibility studies on Sudiffe's 
last 9 issues. Yet, according to the 
bondholders' complaints, the ac- 
countants knew that Sutliffe's earlier 
proiccts were in trouble even as they 
wrote new reports that helped him 
issue his later bonds. 

Touche Ross denied any culpabil- 
ity. But in April a federal court iurv in 
Cincinnati found Touche liable, 
along with Sutlirfe and others, on civil 
charges of complicity to violate secu- 
rities laws and the Racketeer Influ- 
enced and Corrupt Organizations Act 
(RJCO). Price Waterhousc, which was 
to go on trial following Touche, set- 
tied with the bondholders soon after 
the verdict against Touche came 
down. Along with various lawyers and 
bank trustees who acted on behalf of 
First Humanics, Touche and Trice 
Waterhousc hive contributed to an 
unusually hefty settlement totaling 
about S43 million. 

Thanks to that settlement, First 
Humanics may have a relatively happy 
ending for the bondholders. Three of 
its nursing homes have already been 
sold. Some First Humanics' bond- 
holders committee members arc on 
the board of a new company that 
controls the other IS, about half of 
which arc now starting to pay interest. 
This, plus the S43 million settlement, 
means that bondholders could get up 
to SO cents on their invested dollar — 
minus, of course, the costs of inflation 
and forgone interest. 

Investors who bought other high 
yielding nursing and retirement home 
bonds in the mid 1980s are unlikely 
to be so luckv From 1986 through 
this year, 215 of these issues, with an 
aggregate face value of SI. 5 billion, 
defaulted, according to the Bond In- 
vestors Association 

There are rwo morals here. One is 
Don't reach for yield "flic other is 
Don't assume a company is kosher 
just because it is stamped kosher bv a 
famous-name accounting firm ■§ 



Forbes ■ Auimm 17. 19V 2 



172 



TESTIMONY OF 

EDWARD J . RADETICH . JR . . CPA 

BEFORE THE 

UNITED STATES SENATE 

SECURITIES SUBCOMMITTEE 

COMMITTEE ON BANKING. HOUSING AND URBAN AFFAIRS 

JUNE 17. 1993 



Heffler & Company 

CERTIFIED PUBLIC ACCOUNTANTS 






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178 



HEFFI.ER & COMPANY 

CASES WE HAVE HANDLED 

OR ARE PRESENTLY WORKING ON 



Securities Class Action Suits: 

AIA Industries, Inc. 

Aldon Industries, Inc. 

AM International, Inc. 

American Carriers, Inc. 

American Integrity Corp. 

American Medical Buildings 

American Savings & Loan Association of Florida 

Ames Department Stores, Inc. 

Ampex 

Amre , Inc. 

Apache Corporation 

Apollo 

Applied Digital Data Systems, Inc. 

Arizona Public Service 

Atlantic Financial Federal 

Atlantic Dept. Stores, Inc. 

Avant-Garde Computing, Inc. 

AZL 

Beverly Enterprises, Inc. 

Blinder Robinson & Co . , Inc. 

Boardroom Business Products, Inc. 

Braniff, Inc. 

Brickley v. EPIC 

Burroughs Corporation 

Caesars World, Inc. 

California Life Corporation 

Calton, Inc. 

Centocor, Inc./Tocor II, Inc. 

Charter Company 

Cincinnati Gas & Electric Company 

City Fed 

Coleco 

Commodore International Limited 

Computer Devices, Inc. 

Computer Input Services, Inc. 

Crazy Eddie, Inc. 

Cullinet Software, Inc. 

Data Access Corporation 

Data General Corporation 

Digital Equipment Corporation 

Documation 

E. F. Hutton Group, Inc. 

Eliot Savings Bank 

Embassy Suites 

Endo-Lase, Inc. 

Engelhard 

Entourage International, Inc. 

Equitorial Communications 

Falcon Cable Systems 

Farmers Group Stock Options 

Fiberboard 

First City Bancorporation 



179 



HEFFLER & COMPANY 

CASES WE HAVE HANDLED 

OR ARE PRESENTLY WORKING ON 



Securities Class Action Suits: (Continued) 

First Fidelity Bancorporation 

First Jersey Securities, Inc. 

First Service Bank for Savings 

Flagship Financial 

Food Fair 

Fossett Corp. et al. v. Marvin Gerhart et al . 

French v. Pacific Nuclear Systems, et al. 

Fretter, Inc. 

Funds of Letters, Inc. (New America Fund) 

General Host Corporation 

General Public Utilities 

Gilbert v. Bache 

Gillette 

Golden v. Shulman, et al . (Bolar Pharmaceutical) 

Goodyear Tire & Rubber Co. 

Great American Mortgage Investors 

Healthdyne 

Heritage Bancorp, Inc. 

Home Shopping Network Action I 

Home Shopping Network Action II 

Information Displays, Inc. 

Interfirst Corporation 

IGI 

Iomega Corporation 

ITT Corporation 

Katy Industries 

Kay Jewelers, Inc. 

Kendrick v. Atcor, Inc. 

Kirschner Medical Corporation 

La Petite Academy 

Lomas Financial Corporation 

Lomas & Nettleton Mortgage Investors 

Magic Marker 

Mattel 

MBI Business Centers, Inc. 

MCorp. 

Melridge, Inc. 

Meridian Bancorp, Inc. 

Merrimack Bancorp, Inc. 

Microcom, Inc. 

Micropolis Corporation 

Midwestern Companies, Inc. 

Minne tonka 

Mortgage Realty Trust 

National Media Corp. 

Newbridge Networks Corporation 

Norris Oil Co. 

Nutmeg Industries, Inc. 

Nutri/Systems , Inc. 

One Bancorp 

OMNI 



180 



HEFFLER & COMPANY 

CASES WE HAVE HANDLED 

OR ARE PRESENTLY WORKING ON 



Securities Class Action Suits: (Continued) 

ORFA Corporation of America, Inc. 
ORS Automation Systems 
Osrow Corporation 
Pace Membership Warehouse , Inc . 
Pacific Nuclear Systems, Inc. 
Pancoastal 

Pannill Knitting Company, Inc. 
Paradyne 
Pay N' Save 
Penn Central Co . 
Peoples Savings Bank 
Perception Technology Corporation 
Philadelphia Savings Fund Society 
Poughkeepsie Savings Bank/FSB 
Public Service Company of New Mexico 
Quinoco Limited Partnerships 
RAC Mortgage Investment Corp. 

Residential Resources Mortgage Investments Corp. 
Revco D.S., Inc. or ANAC Holding Corporation 
Richard J . Dennis & Company 
Richton International Corporation 
RJR Nabisco, Inc. 
Roper Corporation 

Rospatch Corporation (now known as Ameriwood Industries 

International Corporation) 

Sanders 

Sanifill, Inc. 

Seafirst Corporation 

Sequoia Systems, Inc. 

Sierra Health Services, Inc. 

Singer Company 

SmithKline Beckman Corporation 

Snyder v. Oneok, Inc. 

Spectra Pharmaceutical Corp. 

Spectran Corporation 

Star States Corporation 

Statewide Bancorp 

Systems & Computer Technology Corporation 

Telesphere International, Inc. 

Tucson Electric Power Company 

UCI Medical Affiliates, Inc. 

Union Fidelity Corporation 

U. S. Bioscience, Inc. 

U. S. Healthcare, Inc. 

Verbatim Corporation 

Wall to Wall Sound and Video, Inc. 

Waste Management 

Wedtech Corp . 

Western Union 

Windmere Corporation 

Zayre Corporation 



181 



HFVFT.F.R & COMPANY 

g&g ES UF , HAVF - HANDLED 

OR ARE PRESENTLY WORKING ON 



Anci -Trust Cases: 



Airlines 

Anthracite Coal 

Antibiotics 

Architectural Grade Hinges 

Armored Car 

Bakery Products 

Brass Fittings 

Brass Mill Tube & Pipe 

Burglar Alarms 

Cast Iron Pipe 

Chain Link Fence 

Chemical 

Clozapine 

Concrete Pipe 

D. C. Soft Drinks 

Electrical Products 

Gasoline 

General Adjustment Bureau, Inc 

Glassine & Greaseproof Paper 

Gypsum Wallboard 

Hospital Beds 

Independent Gasoline 

Library Books 

Oil Task Force 

New York Beer 

PASA 

Pittsburgh Asphalt 

Plumbing Fixtures 

Rock Salt 

Rope Industries 

South Florida Soft Drinks 

Steel Wheels 

Tickets 

Uniform Rentals 

Water Meters 

Women's Clothing 



182 



HEFFLER & COMPANY 

CASES 'JE HAVE HANDLED 

OR ARE PRESENTLY WORKING ON 



Other Class Actions: 



Alcolac, Inc. 

Ashland Oil Spill 

Boesky Disgorgement Fund 

Bogosian et al. v. Gulf et al. 

Brunt vs. The Charter Company 

Chase Maryland Rail Collision 

D'Amico v. Conrail 

David S. Haas, et al . v. Philadelphia Department of Revenue 

Drexel Disgorgement Fund 

Giardiasis, Etc. 

Infant Formula 

Jennings vs. Mobil 

Master, Mates & Pilots Pension Plan & IRAP 

Presidential Life Insurance Company v. Milken, et al . Global Class Ac 

Rohm & Haas Company Litigation 

Rosenfeld v. Collins & Aikman Corp. 

Simmons Company Employee Stock Ownership Plan 

Stripper Well Exemption Litigation 

Three Mile Island 



183 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SASSER 
FROM EDWARD R. McCRACKEN 

Q.l. There have been growing complaints about the "litigation ex- 
plosion," particularly against high-technology companies. One of 
the explanations offered to explain the high incidence of securities 
fraud cases filed against high-tech firms is that they tend to be 
volatile on the stock market, and that investors sue the companies 
in order to recoup their losses, whether or not there has been fraud 
or not. Moreover, even if there is no fraud, there is an incentive 
for the company to settle out of court to avoid the cost of litigation. 
Is this really happening? If so, does the law governing private se- 
curities litigation play a role? How could it be reformed to continue 
to protect investors against genuine fraud while also curtailing friv- 
olous lawsuits? 

A.1. Indeed there has been a genuine litigation explosion against 
high technology companies. Regardless of the statistics of lawsuit 
filings, however, the fact is that the high technology industry has, 
and continues, to be targeted by the plaintiffs' bar for securities 
fraud cases. The law governing private securities litigation does in- 
deed play a role, since it enables a law firm, just for the price of 
a filing fee, to file a lawsuit that almost inevitably will result in 
hundreds of thousands of dollars being diverted to the investigation 
and defense, not to mention settlement, of these lawsuits. As pres- 
ently formulated, and as interpreted by the courts, the laws gov- 
erning securities class-action lawsuits permit plaintiffs to bring 
meritless lawsuits with ease; they do not require any real financial 
stake by the plaintiffs in either the lawsuit, or its outcome; and 
they pit law firms (whose sole function is to litigate these sorts of 
lawsuits), against companies who do have productive purposes, i.e., 
research and development, providing manufacturing jobs, and ex- 
porting products. 

Q.2. Critics argue that frivolous litigation is time-consuming and 
distracts chief executives and other corporate officials from produc- 
tive economic activity. They also argue that securities litigation 
seeks huge monetary recoveries from outside directors, outside law- 
yers and independent accountants, who may be only marginally in- 
volved in fraudulent activity for which a corporation should be pri- 
marily liable. 

How does litigation or the threat of litigation, affect your busi- 
ness? In particular, has private securities fraud litigation impaired 
your ability to raise capital? Have you encountered difficulty at- 
tracting qualified persons to serve on your board of directors ? Are 
accounting firms willing to audit your books? 

A*2. As Ed McCracken testified on June 17, securities class-action 
litigation, and its threat, has an ongoing effect on our business. 
The threat of litigation makes us think very carefully about when 
and what we will say about the state of the company's business. 
We know that, with, "20-20 hindsight," virtually everything we 
write about the company or its products will be examined by the 
plaintiffs for use against us in litigation. We think it's obvious that 
if we continually have to look over our shoulders, we are distracted 
from looking ahead. 



184 

Despite the threat of private securities fraud litigation, we have 
been successful, when necessary, in raising capital. However, most 
of the working capital that we have raised has been internally gen- 
erated, i.e., from increasing our markets, watching our expenses, 
and improving profitability. With respect to companies that are less 
well established and less well capitalized than Silicon Graphics, the 
threat of private securities fraud litigation is a continuing issue 
with respect to their ability to raise capital. For those companies 
which experience rapid growth in a fast-changing market, capital 
is an essential engine for building new products, financing inven- 
tory, expanding the channels of distribution and hiring new em- 
ployees. The inability to access capital markets because of the con- 
tinued threat of securities class-action litigation can certainly be an 
inhibitor to growth. 

With respect to attracting qualified persons to serve on a board 
of directors, virtually every potential member of the board of direc- 
tors is concerned afjout his or her exposure to private securities 
fraud litigation and potential personal liability. It is the single 
most formidable barrier to attracting qualified directors. Whether 
the candidates come from business, the community, or the aca- 
demic world, they are all concerned about their personal savings 
being decimated by the cost of defending and settling securities 
class-action litigation. 

In the case of Silicon Graphics, as you know, we have recently 
settled one securities class-action lawsuit and have another lawsuit 
pending that was filed against MIPS Computer Systems Inc., short- 
ly after we announced our intention to merge with MIPS (which we 
acquired in June 1992). Although we believe our own record for in- 
tegrity is unblemished, the insurance company which has been car- 
rying our directors' and officers' liability insurance has stated that 
trie D&O policy would not be renewed at any price. 

The instability in the directors and officers liability insurance 
market, a principal cause of which is the continued threat of hav- 
ing to defend and settle frivolous securities class-action lawsuits, is 
and will continue to be a major concern of those who otherwise are 
willing to serve as directors of America's high growth companies. 

Finally, with respect to whether accounting firms are willing to 
audit our books, we have had no problem with attracting qualified 
auditors. Our own auditing firm, Ernst & Young, has buen with us 
since the company's inception in 1982. The financial reporting prac- 
tices of Silicon Graphics since its founding, as well as the auditing 
practices of Ernst & Young, have always been rigorous and within 
the guidelines set forth by the American Institute of Certified Pub- 
lic Accountants, as well as the rules and regulations of the Securi- 
ties and Exchange Commission. It is a fact, however, that our au- 
dits are much more expensive than otherwise would be the case be- 
cause our auditors are forced to examine every note they make, 
and every piece of paper they create, as if each such document will 
become an exhibit in a securities class-action trial. 

Q.3. Some of the criticisms of the current system may not be mutu- 
ally exclusive. Indeed, while critics of the current system argue 
that steps should be taken to curb litigation, others have argued 
that other steps should be taken to facilitate investor lawsuits, 
such as lengthening the statute of limitations for securities fraud. 



185 

Are these two criticisms of the current system mutually exclu- 
sive? Or, should securities litigation reform and lengthening the 
statute of limitations be considered together? 

A.3. As I understand it, the statute of limitations for securities 
fraud is currently one year after the event of fraud has occurred 
or been discovered. As I said above, I believe that companies, and 
their professional advisors, spend far too much money in thinking 
about every event that could possibly give rise to a securities fraud 
lawsuit, and not enough time on productive pursuits such as ex- 
ploring new technologies, creating new markets, and creating high 
wage, value-added jobs here in America. If the statute of limita- 
tions were made longer, it would mean that we would be looking 
over our shoulders even more than we do today, or creating a 
longer, more complex and expensive "paper trail every time we 
take, or don't take, an action which might become the subject of se- 
curities class-action litigation. Therefore, I believe that lengthening 
the statutes of limitation would create yet another burden for 
America's companies. Statutes of limitations are established so that 
if a dispute arises, people's memories are reasonably fresh about 
those events leading up to the dispute. Since securities class-action 
lawsuits almost invariably deal with "20-20 hindsight" I believe 
that even more abuses would occur if the statute of limitations 
were lengthened. 

As noted above, Silicon Graphics is presently defending a class- 
action lawsuit filed against a company with which it merged, MIPS 
Computer Systems, Inc. This lawsuit purportedly relates to disclo- 
sures (and alleged non-disclosures), made by MIPS between Janu- 
ary 31, 1991 and October 9, 1991. The lawsuit itself was filed on 
March 17, 1992, shortly after the proposed merger was announced, 
and over five months after the last event being complained of took 
place. It is now 1993, two years after these events allegedly took 
place, and we are presently in the discovery stage of the case, in 
which the plaintiffs' attorneys are reviewing thousands of docu- 
ments and taking depositions under oath of former MIPS officers, 
directors, and employees. In this type of lawsuit, the plaintiffs' at- 
torneys, with today's "knowledge," will allege that during this nine 
month period two years ago MIPS officers and employees should 
have said or disclosed certain things about the company's products, 
markets, or financial prospects or should have undertaken certain 
acts they didn't. 

If the statute of limitations were lengthened beyond the present 
one year period, I submit that it would be even more burdensome 
on defendants, and even more difficult to gather documents and re- 
construct events than is currently the case. 

I would be happy to provide any further information requested 
by the Committee. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR BRYAN 
FROM EDWARD R. McCRACKEN 

Q.l. On page 58 of the transcript you state as follows regarding 
what you term "off-the-shelf lawsuits: "What that means, Senator, 
is that the word processing has been done. It's sitting there on the 
shelf. With the computer system that you probably use, you replace 
one company's name with another. Since there's nothing specific 



186 

about it except dates and particular stock prices, the filing can be 
made right off the shelf. It's very cheap." 

Please identify for the subcommittee the specific cases to which 
you refer. 

A.1. This question is best answered by addressing the decisions 
rendered by a few Federal judges who have described this very 
problem. These judges were faced with reading very long com- 
plaints and, in their opinions, charged that the plaintiff did nothing 
more than (i) recite lengthy excerpts from the defendant company's 
public filings and press releases and (ii) proclaim, in rote fashion 
without any factual basis, that all of such statements were fraudu- 
lent. 

In New York, Federal Judge Mukasey dismissed a securities 
class-action complaint because it quoted at great length from news- 
paper articles and reports written by securities analysts without al- 
leging any basis in fact for assuming that Citicorp and its Chair- 
man and Executive Vice President acted to defraud the public. 
Hershfang v. Citicorp, 767 F. Supp. 1251 (S.D.N. Y. 1991). As Judge 
Mukasey put it: 

"Plaintiffs have stitched together a patch-work of newspaper 
clippings and proclaimed the result a tale of securities fraud. But 
by even modest standards of Rules 9(b) and 12(b)(6), it isn't. 
Read as a whole, the complaint creates the strong impression 
that when Citicorp announced a cut in dividends, plaintiffs coun- 
sel simply stepped to the nearest computer console, conducted a 
global Nexis search, pressed the "Print" button, and filed the 
product as their complaint." Id. at 1259. 

In Dallas, Federal Judge Kendall recently chastised plaintiffs for 
drafting a seventy-four page complaint that contained nothing but 
boilerplate, and no facts supporting its allegations of fraud. In re 
URCARCO Sec. Litig., 148 F.R.D. 561 (N.D. Tex. 1993): 

"Plaintiffs' consolidated, amended class-action complaint fails 
... to plead a factual foundation for what are otherwise bare 
conclusions regarding the defendants' state of mind. One wonders 
how a pleading, the textual portion of which covers seventy-four 
pages, could use so many words yet say so little that is really, 
firmly, factually grounded. . . . [T]he complaint offers a section 
regarding "conspiracy, aiding and abetting and concerted action 
allegations," which, as much of the complaint, is characterized by 
rote repetition of buzzwords taken from the pertinent statutes 
and rules. . . . Plaintiffs sample liberally from the IPO prospec- 
tus, simply quoting block passages and, with the help of 20-20 
hindsight, trying to put the right spin on the quotations. . . . 
One begins to understand how the length of seventy-four pages 
can belie its own potential for specificity." 

Judge Kendall found that the allegations of fraud were based 
upon nothing but hindsight. Alluding to the concern with vexatious 
strike suits expressed by the Supreme Court in Blue Chip Stamps 
v. Manor Drug Stores, 421 U.S. 723, 743 (1975), Judge Kendall con- 
cluded that "[plaintiffs' twelve-gauge class-action complaint fails to 
put the defendants on notice of what their alleged wrongful conduct 
was, puts the defendants' reputations at risk of unfounded allega- 



187 

tions and threatens the judicial system with a potential strike 
suit." He dismissed the case with prejudice. 

In the Northern District of California, Federal Judge Walker fol- 
lowed the lead of Judge Mukasey in New York, and dismissed a 
lengthy complaint because it failed to state "a coherent theory of 
securities fraud." In re Wells Fargo Sec. Litig., [1992 Tr. Binder] 
Fed. Sec. L. Rep. (CCH) 1196,830, at 93,307 (N.D. Cal. 1991), ap- 
peal pending, No. 92-15344 (9th Cir. filed Jan. 22, 1992). After sift- 
ing through a complaint bloated with block quotations and rote al- 
legations of fraud, Judge Walker concluded that plaintiffs had 
failed to explain simply and clearly why the defendants were guilty 
of fraud: 

"Nothing in plaintiffs' voluminous complaint states facts which 
support a coherent theory of securities fraud. . . . Despite a com- 
plaint of 59 pages, containing 134 paragraphs of allegation, 
plaintiffs' counsel was unable to point to one paragraph or set of 
paragraphs which provide the facts necessary to infer fraud in 
the purchase or sale of securities * * * [PJlaintiffs cite annual 
reports, quarterly reports, banking regulations and newspaper 
articles . . . [b]ut nowhere does the complaint link the facts stat- 
ed to a coherent theory of securities fraud." 

With word processors and electronic databases plaintiffs can 
launch these cases with very little effort. The format of each com- 
plaint is the same and plaintiffs need only insert a few details 
about the company and some block quotations from its public fil- 
ings, press releases, and the reports of securities analysts, and 
then proclaim, without any basis in fact, that all of these state- 
ments are infected with fraud. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOMENICI 
FROM EDWARD R. McCRACKEN 

Q.l. Some witnesses asserted that current versions of Rule 11 and 
Rule 9(b) of the Federal Rules of Civil Procedure provide sufficient 
protection against meritless suits. Would you or your company's 
general counsel comment on that assertion? 

A.1. I strongly disagree with that assertion, because courts have 
not been willing to enforce these rules as strictly as they are writ- 
ten. Rule 9(b) requires that all allegations of fraud must be pleaded 
with particularity. Rule 11 requires that sanctions be imposed for 
pleadings filed without a reasonable basis in fact. 

Yet, courts often let a securities class action go forward even 
though the plaintiff does no more than allege that the company's 
future was not as favorable as stated in prior press releases. Tne 
core of the problem is that courts do not apply Rules 9(b) and 11 
to require the plaintiff to allege a believable theory about why they 
think that the company and its senior officers defrauded the invest- 
ing public. Instead, plaintiffs focus on or obscure certain facts in 
order to have the courts accept a pleading. For example, plaintiffs 
usually include standard allegations of a conspiracy between the of- 
ficers and directors to inflate the market price of the company's 
stock for their benefit. If officers and directors sell their holdings, 
plaintiffs will allege that the insiders "bailed out" as part of their 
scheme to defraud. On the other hand, if the insiders sold just a 



188 

part of their holdings, in a move to diversify their investments, and 
still retained a large stake in the company, plaintiffs will still al- 
lege fraud, even though the remainder of the insiders' investment 
suffered the same fate as that of the public shareholders. And, of 
course, plaintiffs refuse to accept that the complete lack of insider 
selling is cause to dismiss their complaint. If the courts would 
strictly apply Rules 9(b) and 11 in a way that insisted on a consist- 
ent and coherent theory of fraud, many of the cases would be elimi- 
nated. However, as long as the courts allow the plaintiffs' bar to 
pick and choose among the same categories of information to fash- 
ion these complaints, the threat of sanctions will be a hollow one. 

Q.2. Changes to Rule 11 have been proposed to make the award 
of sanctions permissive, rather than mandatory; to make the sanc- 
tions payable to the court rather than the injured party; to make 
the rule inapplicable to the discovery process and to create a safe 
harbor that would bar the award of sanctions if the challenged 
pleading was withdrawn by the alleged offender within 21 days of 
service of a motion for sanctions, among other changes. Would the 
proposed changes in Rule 11 provide greater or lesser protection 
against meritless suits? 

AJ2. These changes would reduce to nil any potential deterrent ef- 
fect of Rule 11. They would fail to compensate the company, which 
probably spent hundreds of thousands or millions of dollars getting 
the case dismissed. And they would leave plaintiffs free to pursue 
wide-open harassment of defendants during discovery, in the hope 
that by making discovery burdensome and expensive, defendants 
will settle. 

Q.3. How long did it take to get your case dismissed? How much 
of your own time was expended in activities related to getting the 
case dismissed? 

A.3. The original complaint against Silicon Graphics was filed on 
May 23, 1991, and was dismissed on March 23, 1992. Plaintiff re- 
quested leave to file an amended complaint, which the court grant- 
ed. The defendants then challenged the certification of the plaintiff 
as the class representative and the Court agreed that there were 
serious questions about that issue and requested more briefing. 
Thereafter, the case was settled and the amended complaint was 
dismissed on July 2, 1993. 

Silicon Graphics' officers and employees collectively spent a great 
deal of time on the case. Without disclosing attorney-client commu- 
nications or our attorneys' work product, I can say that our attor- 
neys conducted a thorough investigation of the period in question 
and interviewed all relevant corporate officers and employees. In 
addition, Silicon Graphics' officers and employees spent many 
hours assisting our attorneys in collecting all documents that were 
responsive to me broad document production requests made by the 
plaintiff. Silicon Graphics executives regularly conferred with our 
in-house counsel and met with our outside attorneys as needed. 
Obviously, this time could have been spent on productive work. 

Q.4. How much did it cost you in legal fees? 

A.4. The lawsuit was filed in May 1991 and settled in July 1993. 

Defense attorneys' fees and defense costs totaled almost $500,000. 



189 

Q.5. One of the witnesses later in the day will testify that Harvey 
Pitt, a leading lawyer for the defendants in securities cases, has 
written that "Federal courts have displayed a striking willingness 
to dismiss these suits." 

Harvey Pitt testified before this subcommittee at an earlier hear- 
ing that he routinely counsels his clients to settle these types of 
cases regardless of the merits because it is the only option that 
makes economic sense. 

I don't want you to necessarily respond to your own experiences, 
but you know many other CEOs with cases similar to yours. Have 
you ever heard anyone complain that their lawyers tell them that 
the only option that makes economic sense is to settle and to get 
on with life and business? 

A.5. I believe that many executives of high technology companies 
have found that settlement of these cases is in the best economic 
interests of their company and shareholders. The potential dam- 
ages in one of these lawsuits is enormous; in many cases, the dam- 
ages would be enough to bankrupt the company. These cases also 
are very expensive to litigate, and usually cost several hundred 
thousand dollars just to complete the production of documents and 
initial witness interviews. These economic realities have led many 
corporations to settle. To take a simple example, if the potential 
damages are $100 million, and it will cost $3 million to take the 
case to trial, then even if we think our chances of winning ulti- 
mately are 90 percent, it may be a rational business decision to set- 
tle for some fraction of $13 million, which is the discounted likeli- 
hood of losing plus attorneys' fees. Of course, this simple example 
does not even take into account the hours of productive time that 
will be taken away from key corporate officers. I cannot adequately 
express how heavily this burden weighs on CEOs of high tech com- 
panies. 

Q.6. Each of you had lawsuits triggered by a drop in your stock's 
price. What has happened to your stock in the period since the law- 
suits were filed and the time the cases were settled or dismissed? 

A.6. Following the disclosure of the disappointing results of the 
March 1991 quarter, Silicon Graphics stock fell from about $40 to 
$36. Within a month, however, it bounced back and was soon trad- 
ing above $40. After that, reflecting Silicon Graphics' success over 
the last two years, the stock continued to rise. In February 1992, 
the Board authorized a 2 for 1 split. On a post-split basis, the stock 
has recently been trading above $42.00 per share. In short, some- 
one who invested in Silicon Graphics in 1991 has doubled her 
money. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SASSER 

FROM JOHN G. ADLER 

Regarding your letter dated June 28, 1993, thank you for the op- 
portunity to respond to Senator Jim Sasser's questions concerning 
testimony given at the Securities Subcommittee Hearing held on 
June 17, 1993. At your request, the response format repeats the 
questions asked, then provides an answer. 



190 

Q.l. Do companies have a high incentive to settle out of court to 
avoid the cost of litigation even where no fraud has occurred? Does 
the law governing private securities litigation play a role? 
A.1. High-tech companies, which tend to be volatile on the stock 
market, indeed have a strong incentive to settle out of court solely 
in order to avoid the cost of litigation, even where no fraud has oc- 
curred. Once a class-action securities suit has been filed, high-tech 
companies are immediately placed in a "no win" situation, where 
any victory at trial is a pyrrhic one. The settlement amounts of- 
fered by plaintiffs are often equal to or just below the "hard" (ac- 
tual dollar) costs to fight the suit. When "soft" costs (such as man- 
agement time and mindshare) are factored in, the cost differential 
becomes significant. When the risk factor of a potential loss (result- 
ing perhaps from jury confusion, but not necessarily resulting from 
a company's malfeasance) is added to the equation, the pressure to 
settle becomes compelling, regardless of the merits of the suit. 

Moreover, officers ana directors are responsible, among other 
things, for maximizing shareholder value. Even were a company to 
decide to fight the lawsuit through trial (and all appeals) and win, 
the corporation cannot recover its attorneys fees, sunk time or lost 
opportunity costs. Although its name is "cleared," the costs associ- 
ated with the fight may be, on balance, too high a price to pay 
when viewed from the perspective of maximizing shareholder 
value. Under the present system it is not surprising that so many 
companies believe they have no real choice but to settle. 

Current laws exacerbate the situation. Securities laws have been 
written in a one-sided, pro-plaintiff manner. The laws can cast a 
broad net in an attempt to cover a wide variety of actions, and at 
the same time attempt to make access to the courts as easy as pos- 
sible. They make no provision for restitution to an innocent defend- 
ant. The fee for filing a suit is nominal, a mere $125. Once a suit 
is filed, Federal rules of civil procedure, as interpreted by the Unit- 
ed States Supreme Court, require that courts may not dismiss a 
claim "unless it appears beyond doubt that the plaintiff can prove 
no set of facts in support of his claim which would entitle him to 
relief." It is unreasonable to expect a court, in the beginning of 
complex litigation, to presuppose that no set of facts could possibly 
exist which would support a claim. Because a motion to dismiss, 
when granted, takes the place of a plaintiffs "day in court," in 
practice many courts take a "wait and see" approach. 

Unfortunately for American business, the "wait and see" ap- 
proach allows the litigation to move into the next phase: discovery. 
In discovery, plaintiffs can ask for virtually all the documentation 
produced by a company over extended periods of time. Thus for the 
nominal filing fee, plaintiffs immediately can cause defendants to 
have to incur significant defense costs. In Adaptec's case, for exam- 
ple, the initial class period claimed by the plaintiffs was well over 
a year long, and defense costs just up through written discovery 
only exceeded $1.5 million. Even were Adaptec to continue its fight 
to clear its name and win, Adaptec cannot recover its costs. 

In addition, the unlimited discovery rules enable plaintiffs to 
subpoena customers and customers' records, which has a chilling 
effect on sales to these customers, harming Adaptec's competitive- 
ness. Who will buy products from a company if it means time and 



191 

aggravation to respond to a subpoena?! Considering the "hard" dol- 
lar costs of defense and "soft" costs such as management time, op- 
portunity costs, adverse publicity, customer annoyance, diversion of 
human and other resources and time, there is a very strong incen- 
tive for the company to settle out of court. 

Q.2. How does litigation or threat of litigation affect your business? 
Have you encountered difficulty attracting qualified persons to 
serve on your board of directors? Are accounting firms willing to 
audit your books? 

AJ2. Litigation and its threat absolutely harms our business. It re- 
quires us to divert money away from R&D efforts and other busi- 
ness related purposes, which slows our development efforts and de- 
creases our ability effectively to compete in the global marketplace. 
It causes us to provide less information rather than more to the 
shareholders for fear that in the intervening period of time cir- 
cumstances may change which would lead to allegations of mis- 
representation. It requires us to create and maintain a number of 
purely administrative positions to perform record-keeping and doc- 
ument repository functions, which adds no value to our product and 
burdens our bottom line. Finally, it discourages qualified people 
from serving on the board of directors. I personally refuse to serve 
on the board of public companies due to this liability. 

And although accounting firms are willing to audit our books, 
their procedures, in response to this threat, have become increas- 
ingly demanding and difficult, once again requiring additional re- 
sources by Adaptec personnel and management in order to respond 
to their additional procedures solely to "create the record" in order 
to rebut potential allegations. These additional procedures go be- 
yond qualitative record-keeping, but rather require the creation of 
records for records sake. (Incidentally, these additional records 
later serve to create a greater burden under the discovery require- 
ments should a lawsuit actually be filed.) 

Q.3. Should the statute of limitations for securities fraud be length- 
ened? 

A.3. Because the current system allows such abuse, lengthening 
the statute, in my opinion, would only serve to increase the number 
of these frivolous suits. For example, under the current laws, plain- 
tiffs in Adaptec's case were able to claim a class period that went 
back well over a year. It defies credibility that the company and 
its officers could be so prescient as to calculate the drop in stock 
(which triggered the lawsuit against Adaptec) a full year before 
that particular stock drop occurred. No sales by officers were made 
during the quarter during which the triggering stock drop occurred. 
The stock price during that year had fluctuated both above and 
below the trigger. 

Thank you for the opportunity to clarify these issues. If there are 
any additional questions or points of clarification in which we can 
assist you in understanding the incredible damage being inflicted 
on United States business and its competitiveness in the global 
marketplace, please do not hesitate to contact me at 408-945-8600. 



192 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR BRYAN 

FROM JOHN G. ADLER 

We received a letter from Don Riegle, Chairman regarding testi- 
mony given by John G. Adler, Chairman of the Board and CEO of 
Adaptec, Inc. relating to testimony made by Bill Lerach to the Se- 
curities Subcommittee hearing on private litigation under Federal 
Securities Laws. At your request, the response format repeats the 
questions asked, then provides an answer. 

Q.l. You stated that you had received discovery demands contain- 
ing 105 broad requests, including such items as "all documentation 
that refers to sales or orders in general, all documents that discuss 
or refer to profit margins at Adaptec. We produced over 1,500 boxes 
of paper, Senator, at a cost of almost a million and a half dollars." 
You asked whether we actually produced all of these documents for 
the plaintiffs and how much of this material did we produce. 
A.1. We produced all of the documents requested by the plaintiffs, 
as stated, which documents consisted of over 1,500 boxes of paper. 
Attached for your information is a copy of the broad based discov- 
ery requests to which we needed to respond. 

Q.2. We stated that we were unable to fill an opening on our Board 
of Directors due to concerns about litigation. You requested precise 
information about the opening and questioned whether the Board 
position was still open. 

A3. The Board position is still open and we are seeking a director 
whose qualifications consist of a CEO position of a non-competing 
company, familiar with the industry. 

Q.3. You queried whether defense counsel attempted to have this 
suit dismissed on grounds that it was not pleaded with specificity. 
A.3. Plaintiffs amended their pleadings and our Motion to Dismiss 
on grounds of specificity was denied. 

Q.4. You questioned the basis of the statement that "virtually all 
of the motions to dismiss in the Federal courts in Northern Califor- 
nia have been denied." 

A.4. Once a suit is filed, the Federal Rules of Civil Procedure, as 
interpreted by the United States Supreme Court, require that 
courts can not dismiss a claim "unless it appears beyond doubt that 
the plaintiff can prove no set of facts in support of his claim which 
would entitle him to relief." (emphasis added) It is unreasonable to 
expect that a court, in the beginning of complex litigation, would 
presuppose that no set of facts could possibly exist which could 
support a claim. When the broad net cast by the securities laws is 
added to the virtually unlimited hypothetical realm that must be 
eliminated before a case can be dismissed, dismissal rarely occurs. 
Unless a case is dismissed at the outset, plaintiffs can ask for 
virtually any and all documentation produced by a company over 
extended periods of time. Rules 11 and 9(b) provide the judge with 
ammunition only against "frivolous" motions and claims. Just as a 
court will not dismiss a claim unless there is no possibility that a 
claim could exist, similarly courts often cannot award sanctions 
against the "fishing expedition" allowed by discovery rules, espe- 
cially when read in conjunction with the broad mandate of the se- 



193 

curities laws. The laws may work where there is a clear, inten- 
tional malfeasance, however, many innocent companies like 
Adaptec are forced into an untenable position of having to expend 
massive funds in response to virtually unlimited discovery claims, 
and divert extensive management time, all without recourse and 
without opportunity for restitution. In this manner the Federal 
Rules of Civil Procedure are very ineffectual in practice to discour- 
age meritless suits. 

We hope this clarifies the untenable position into which many in- 
nocent companies are thrown as a result of the interaction between 
current securities laws and the Federal rules of Civil Procedure. 
Please do not hesitate to contact me if you have any additional 
comments or questions, or if I may be of any additional service in 
any way. 



194 



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WILLIAM S. LERACH (68581) 
ALAN SCHULMAN (128661) 
DANIEL J. MOGIN (95624) 
ELLEN A. GUSIKOFF (144892) 
MILBERG WEISS BERSHAD 

SPECTHRIE t LERACH 
225 Broadway, suite 2000 
San Diego, CA 92101 
Telephone: 619/231-1058 

EUGENE A. SPECTOR 

EUGENE A. SPECTOR & ASSOCIATES 

15th & Locust Streets 

Lewis Tower Building, Suite 624 

Philadelphia, PA 19102 

Telephone: 215/545-5335 

ARTHUR N. ABBEY 

ABBEY & ELLIS 

212 East 39th Street 

New York, NY 10016 

Telephone: 212/889-3700 

Attorneys for Plaintiffs 

[Additional counsel appear on signature page.] 



UNITED STATES DISTRICT COURT. 

NORTHERN DISTRICT OF CALIFORNIA 

SAN JOSE TIVISION 



REc e/veo 

MAR 28jagj 



•cassias, 



ELLIOT TOLAN, et al., 

Plaintiffs, 
vs. 
JOHN G. ADLER, et al.. 

Defendants. 



Civ. No. 

C-90-20710-WAI (PVT) 

CLASS ACT-TON 

PLAINTIFFS' FIRST REQUEST 
FOR PRODUCTION OF 
DOCUMENTS TO DEFENDANT 
ADAPTEC, INC. AND THE 
INDIVIDUAL DEFENDANTS 



195 



ADAPTEC 

Service List - 02/25/91 

Page 1 



COUNSEL FOR PLAINTIFF(S) 

•Arthur N. Abbey 
ABBEY & ELLIS 
212 East 39th Street 
New York, NY 10016 

212/889-3700 

212/684-5191 (fax) 

•Eugene A. Spector 
EUGENE A. SPECTOR £ ASSOCIATES 
225 South 15th Street 
Lewis Tower Building, Suite 624 
Philadelphia, PA 19102 

215/545-5335 

215/545-4412 (fax) 

•Richard Schiffrin 
SCHIFFRIN & CRAIG, LTD. 
2020 North Halsted Street 
Chicago, IL 60614 

312/528-6646 

312/528-6780 (fax) 



•Robert N. Kaplan 
KAPLAN & KILSHEIHER 
685 Third Avenue, 26th Floor 
New York, NY 10017 

212/687-1980 

212/687-7714 (fax) 

'Sherrie R. Savett 
Jean Markey 

BERGER i MONTAGUE, P.C. 
1622 Locust Street 
Philadelphia, PA 19103 

215/875-3000 

215/875-4604 (fax) 

'I. Stephen Rabin 
LAW OFFICES OF I. STEPHEN RABIN 
685 Third Avenue, 26th Floor 
New York, NY 10017 

212/682-1818 

212/687-7714 (fax) 



COUNSEL FOR DEFENDANTS 

Janes A. Diboise 

Clifford A. Chanler 

WILSON, SONSINI, GOODRICH & 

R0SATI 
Two Palo Alto square, Suite 900 
Palo Alto, CA 94306 

415/493-9300 

415/493-6814 (fax) 



♦served via United States regular mail. 



196 



1 TO ALL DEFENDANTS AND THEIR COUNSEL: 

2 Pursuant to Rule 34 of the Federal Rules of Civil Procedure 

3 ("Fed. R. Civ. P."), plaintiffs request that defendant Adaptec, 

4 Inc. and the Individual Defendants, and each of them, produce for 

5 inspection and copying the documents described herein which are in 

6 the possession, custody, or control of said defendants or their 

7 officers, agents, employees, cr attorneys, the production of which 

8 shall be at such times and places as may be agreed upon by counsel 

9 for the parties. Defendants shall further comply with Fed. R. Civ. 

10 P. 34(b) by producing said documents as they are kept in the usual 

11 course of business or shall organize and label them to correspond 

12 with the categories in this Request. Defendants shall supplement 

13 their responses under Fed. R. Civ. P. 26(e). 

14 I. DEFINITIONS 

15 1. The tern "communicate" or "communication" as used herein 

16 means every manner or means c: disclosure, transfer, or exchange 

17 of information, whether orally or by document, and whether face- 

18 to-face, by telepnone, mail, personal delivery, or otherwise. 

19 2. "Document" or "documents" is used in the broadest sense 

20 and means, without limitation, any written, printed, typed, 

21 recorded, or other graphic materials including all attachments 

22 added or attached thereto, any information or data stored in or by 

23 computers, or on computer tapes or disks, all photographic or other 
2 4 reproduction thereof, any computer printout of any such documents 
2 5 or data, photographs, and any other paper, letter, correspondence, 
26 memoranda, report, diary, log, calendar, analysis, workpaper, 
27 

28 

PLAINTIFFS* FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 1 - 



197 



1 | notation, tape recording, telegram, mailcram, or any other tangible 

2 U material on which there is any recording or writing of any sort. 

3 | 3. The term "financial statements" as used herein includes, 

4 | but is not limited to, the following, whether audited or unaudited, 

5 U and whether final, interim, pro forra, complete or partial; 

6 I consolidated and unconsolidated balance sheets; statements of 

7 earnings; revenues, profits and losses; additional paid-in- 

8 capital; retained earnings or source and applications of funds; 

9 cash-flow projections; notes to each of such statements; and any 

10 other statements and notes vhich pertain to the applicable 

11 defendant's past or present f inar.rial condition, including 

12 accountants' workpapers. 

13 4. The terms "you" or "your" refer to the named defendants. 

14 5. The term "Individual Def er.oar.ts" as used herein means 

15 defendants John G. Adler, Laurence E. Boucher, Robert J. Loarie, 

16 David F. Marquardt, B. J. Moore, v. Ferrell Sanders, Paul G. 

17 Hansen, Jeffrey A. Miller and Bernard C-. Nieman. 

18 6. The term "Adaptec" or the "rorpany" as used herein, means 

19 Adaptec Inc. and any other corporation, partnership, association 

20 or other entity, whether a subsidiary or otherwise related to 

21 Adaptec Inc., which is controlled, by reason of stock ownership or 

22 otherwise, by Adaptec. 

23 7. The term "SCSI" as used herein refers to the Small 
2 4 Computer System Interface developed cy Adaptec as an I/O protocol 
2 5 standard that allows a microcomputer to communicate with peripheral 
2 6 devices. 
27 

28 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 2 - 



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198 



8. The term "Arthur Andersen" as used herein refers to 
Arthur Andersen t Co., and its merged, consolidated or acquired 
predecessors or successors, its divisions, subsidiaries or 
affiliates including, but not limited to, present or former 
partners, directors, officers, agents, employees, attorneys or 
other persons acting or purporting to act on its behalf, or on 
behalf of its predecessors, successors, subsidiaries or affiliates. 

9. The term "meeting" as used herein means any simultaneous 
presence of or telephone conversations between persons acting or 
purporting to act for the defendant herein answering, and any other 
persons whether such was by chance, prearranged, formal, or 
informal . 

10. The term "Other Defendants" as used herein means any 
defendant other than the defendant responding to this Request for 
Production. 

11. The term "person" or "persons" as used herein refers tc 
natural persons, proprietorships, corporations, partnerships, joint 
ventures, firms, associations, organizations, governmental bodies, 
agencies, boards, authorities, commissions, or any other entities 
of any type, 

12. The term "policy" as used herein means any rule, 
procedure, directive, practice, or course of conduct, whether 
formal or informal, written or unwritten, recorded or unrecorded. 

13. The use of the singular shall be deemed to include the 
plural, and vice versa; and the use of one gender shall include the 
other, as appropriate in the context. 



PLAINTIFFS* FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 3 



199 

1 | II. TNSTKUCTIONS 

2 I If any documents were within the scope of any request for 

3 I production but are not being produced pursuant to any claim of 

4 privilege or confidentiality, identify such document (including, 

5 where applicable, the date, general description, author and 

6 addressee) , specify the nature of the privilege claims for each 

7 document and specify the identity of the person on whose behalf the 

8 privilege is asserted, and provide the information specified in 

9 Local Rule 230-5 of the Northern District of California and the 

10 District's "Guidelines for Discovery Motion Practice and Trial" 

11 (1989). 

12 III. TIME PERIOD 

13 Unless otherwise stated in a Request, all documents requested 

14 are for the period January :, 1989 through the Present (the "Time 

15 Period"). 

16 IV. DOCUMENTS REQUESTED 

17 REQUEST NO. 1 : 

18 All documents which constitute, evidence or refer to Adaptec's 

19 policy regarding document destruction or retention. 
2 REQUEST NO. 2 : 

21 All insurance policies and indemnification agreements which 

22 cover or which could cover claims asserted in this action or any 

23 claims asserted against Adaptec or the Individual Defendants under 

24 the federal securities laws. 

25 REQUEST NO. 3 : 

26 All documents which constitute, evidence or relate to any 

27 presentations made at Adaptec's annual meetings of shareholders. 



28 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS 



1 

2 
3 
4 
5 

6 

7 

8 

9 

10 



200 



gEfflffigI NQ - 4i 

All organizational chares or other documents describing 

Adaptec, its subsidiaries, affiliates, divisions, departments, 

units or other corporate subdivisions and the relationships among 

them, and the names and/or reporting relationships of Adaptec's 

officers, directors, and executives during the time period. 

REQUEST NO. 5; 

Adaptec's Articles of Incorporation and By-Laws, including all 
amendments thereto. 

REQUEST NO. 6 : 



11 All documents that constitute, discuss or refer to any news 



12 
13 
14 
15 
16 
17 
18 
19 
20 
21 
22 
23 



25 
26 
27 
28 



article about the Company. 
REQUEST NO. 7: 

All documents that constitute, memorialize, refer to or 
discuss any meetings of or discussions at Adaptec's Board of 
Directors or any committee thereof, including, but not limited to, 
all notes taken at the meetings. 

REQUEST NO. 8 : 

All Adaptec press releases or other communications to the 
media, and all documents which constitute, evidence or refer to the 
preparation of any press release, public announcement or 
communication and all news articles, periodical and magazine 
articles, the subject of which in whole or in part relates to or 



24 refers to Adaptec or any of the Individual Defendants. 



REQUEST NO. 9 : 

All documents distributed cr utilized at any meeting of 
Adaptec's Board of Directors cr committees thereof. 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND TKZ INDIVIDUAL DEFENDANTS - 5 - 



201 



1 REQUEST NO. 10 : 

2 All documents distributed or utilized at any meeting of any 

3 Adaptec management, audit or executive committee. 

4 REQUEST NO. 11: 

5 | All minutes, agendas and other documents which evidence or 

6 I refer to meetings of the Adaptec Board of Directors and any 

7 committees thereof including, but not limited to, the Management 

8 Committee, the Executive Committee, and the Audit Committee. 

9 REQUEST NO. 12: 

10 All documents that constitute, memorialize, refer to or 

11 discuss any meetings of or discussions at any Adaptec management 

12 or executive committee meetings, including, but not limited to, all 

13 notes taken at the meetings. 

14 REQUEST NO. 13: 

15 All documents which constitute, evidence or refer to 

16 presentations to securities analysts, individually or in groups of 

17 two or more, or which evidence any communications or contacts with 

18 securities analysts. 

19 REQUEST NO. 14 : 

20 All logs, digests, notes cr any other documents memorializing 

21 meetings with or telephone calls received from or held with 

22 securities analysts, or with representatives of newspapers or 
2 3 periodicals by Adaptec or the Individual Defendants, or any 

24 | representative or employee thereof. 

25 REQUEST NO. 15: 

26 All documents which memorialize, refer to or discuss any 

27 K meeting or communication with any investment banking entity, any 

28 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 6 - 



202 



1 security rating service, any securities or financial analyst, or 

2 any representative of the news media, or trade press relating to 

3 the Company or its securities, including, without limitation, any 

4 presentations, minutes, notes or transcripts of any such meetings 

5 and communications. 

6 REQUEST NO. 16 i 

7 All documents prepared during the relevant period that discuss 
6 whether any public disclosure should be made regarding any aspect 
9 of the Company's financial or business results, prospects, 

10 forecasts or projections. 

11 REQUEST NO. 17: 

12 All documents that constitute, refer to or discuss speeches 

13 or presentations before the American Electronics Association or any 

14 similar industry organizations. 

15 REQUEST NO. 18: 

16 All documents which memorialize, refer to or discuss any 

17 meeting or communication with the Aaerican Electronics Association. 

IB REQUEST NO. 19: 

19 Videotapes, overhead projections, slides or other materials 

20 used in making presentations to securities analysts. 

21 REQUEST NO. 20: 

22 All documents that constitute, discuss or refer to any 
2 3 financial analyst's report about the Company. 

24 REQUEST NO. 21 t 

25 All documents sent to securities analysts generally or any 

26 individual securities analyst by Adaptec or any of the Individual 

27 | Defendants. 

28 | 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 

11 DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 7 - 



203 



1 BEQUEST WO. 22; 

2 All documents that constitute, refer to or discuss any 

3 communications or meetings between Adaptec or any of the Individual 

4 Defendants and any public relations firm. 

5 REQUEST NO. 23; 

6 All documents which constitute, evidence or refer to inquiries 

7 from or responses to stock market analysts or any regulatory body 

8 regarding trading by the Individual Defendants in Adaptec common 

9 stock. 

10 BEQUEST NO. 24: 

XX All Adaptec stock transfer records and stock register records 

12 for the period September 29, 1989 through December 12, 1990; and 

13 all documents relating to or referring to the volume of trading in 

14 Adaptec common stock and the market price of Adaptec's stock. 

15 REQUEST NO. 25; 

16 All documents constituting or reflecting communications with 

17 the Securities and Exchange Commission, NASDAQ, National 

18 Association of Securities Dealers, or Adaptec shareholders, 

19 including general mailings and individual communications and drafts 

20 thereof. 

21 REQUEST NO. 26 ; 

22 All documents that constitute, refer to or discuss any Adaptec 

23 filing or report to shareholders with the SEC during fiscal years 

24 1989, 1990 and 1991. 
25 

26 
27 

28 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 8 - 



204 



1 REQUEST NO. 27: 

2 All documents which constitute, evidence or refer to the 

3 policy of Adaptec regarding purchase or sale of Adaptec common 

4 stock by company employees, officers or directors. 

5 REQUEST NO. 28: 

6 | All documents which constitute, evidence or refer to any plan 

7 which provides for compensation of officers, directors, and 

8 executives through the issuance of Adaptec common stock or Adaptec 

9 common stock options and all documents which describe or explain 

10 the method of operation of sucn plan. 

11 REQUEST NO. 29 : 

12 All documents which constitute, evidence or refer to any plan 

13 which provides for bonus corcpensation of officers, directors, 

14 executives and sales force merxiers of Adaptec including, but not 

15 limited to, the Adaptec Senior Management Bonus Plan and Adaptec's 

16 Incentive Bonus Plans. 

17 REQUEST NO. 30 : 

18 All documents sent or received by any Individual Defendant to 

19 or from any other Individual Defendant which refer to the financial 
2 | condition of Adaptec or the purchase, acquisition, or sale of 

21 I Adaptec securities. 

22 I REQUEST NO. 31: 

23 I For the period 1989 to date, all documents which evidence or 

24 | refer to loans obtained by any of the Individual Defendants, the 

25 proceeds of which were used to acquire Adaptec common stock or 

26 Adaptec common stock options 
27 

28 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 9 



205 



1 REQUEST NO. 32 : 

2 All documents which constitute, evidence or refer to any 

3 communications sent or received by an Individual Defendant to or 

4 from any person not a defendant herein regarding purchase, 

5 acquisition, or sale of Adaptec common stock, common stock options, 

6 incentive stock rights, stock appreciation rights, stock purchase 

7 rights or the financial condition of Adaptec. 

8 REQUEST NO. 33: 

9 All documents which evidence or refer to the purchase, sale 

10 or transfer of Adaptec securities by any officer or director of 

11 Adaptec, by members of their immediate families (parents, siblings, 

12 spouse and children), or by any entity (trust, partnership, etc.) 

13 which they control or in which they had interests, or the intention 

14 to purchase or sell Adaptec securities, including, but not limited 

15 to, communications from stock brokers, Form 144s, and documents 

16 evidencing any communications between any of the Individual 

17 Defendants referring to such purchases or sales. 

18 REQUEST NO. 34 : 

19 All documents which evidence cr refer to the purchase, 

20 acquisition, transfer or sale of Adapter common stock, common stock 

21 options, incentive stock rights, stock appreciation rights or stock 

22 purchase rights by the Individual Defendants, their immediate 

23 families or any entity as described in paragraph 33 herein from 

24 January 1, 1988 to date, setting forth date of transaction; number 

25 and type of securities purchased or acquired or sold, or disposed 

26 of; the price per share; and any net proceeds realized. 
27 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 

1 DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 10 - 



206 



i 



REQUEST NO. 35: 



2 I All documents which constitute, evidence or refer to reports 
nade by the Individual Defendants to Adaptec regarding the 
purchase, acquisition, or sale of Adaptec common stock, common 
stock options, incentive stock rights, stock appreciation rights 

6 I or stock purchase rights by the Individual Defendants. 



7 

8 

9 

10 

11 

12 

13 

14 

15 

16 

17 

18 

19 

20 

21 

22 

23 

24 

25 

26 

27 

28 



REQUEST NO. 36: 

All documents which set forth, discuss or otherwise consider 
the market price of Adaptec securities. 
REQUEST NO. 37 : 

All documents which constitute, evidence or refer to adopting 
the Adaptec, Inc. 1990 stock plan. 
REQUEST NO. 38: 

All documents which constitute, evidence or refer to adopting 
the 1990 Directors Option Plan. 
REQUEST NO. 39: 

Diaries, daybooks, calendars, appointment books, telephone 
logs or similar documents, maintained for, by, or of each of the 
Individual Defendants. 
REQUEST NO. 40 : 

Curriculum vitae or resumes for each of the Individual 
Defendants. 
REQUEST NO. 41: 

Adaptec personnel files regarding each of the Individual 
Defendants. 
REQUEST NO. 42 : 

Adaptec personnel files regarding each of the following 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 11 - 



207 



1 San Kazarian Christopher G. O'Meara 

2 Donald P. Landry Lawrence 0. Sasscer 

3 G. Roger McLean Thomas C. Stoiber 

4 G. Venlcatesh Henry P. Massey, Jr. 

5 REQUEST NO. 43; 

6 All personnel files regarding individuals who at anytime 

7 during the Time Period held the following positions at Adaptec: 

8 (a) Financial officer; 

9 (b) Controller; 

10 (c) Assistant Controller; 

11 (d) Secretary; 

12 (e) Treasurer; and 

13 (f) Sales Manager for eacn Adaptec sales district or region. 

14 REQUEST HO. 44 : 

15 For each of the Individual Defendants, all documents which 

16 constitute, evidence, cr refer to employment contracts between 

17 Adaptec and each of the Individual Defendants. 

18 REQUEST NO. 4 5 : 

19 For each of the Individual Defendants, all documents relating 

20 to compensation, to any emoluments or other benefits paid to or 

21 accrued for the Individual Defendants. 

22 REQUEST NO. 46 : 

23 | All documents which constitute, evidence or refer to (non- 
24 I litigation) complaints, court actions, non-court proceedings, and 

25 arbitration proceedings asserted by former employees of Adaptec 

26 against Adaptec. 
27 

28 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 12 - 



208 



1 REQUEST NO. 4-7 : 

2 All Adaptec personnel files for any individuals who are 

3 parties to any of the complaints, actions or proceedings identified 

4 in response to the preceding document, request. 

5 REQUEST NO. 48 ; 

6 All files maintained by Adaptec's public relations department 

7 which constitute, evidence or refer to news articles written or 

8 published about Adaptec or any of the Individual Defendants. 

9 REQUEST NO. 49 : 

10 All financial or operating reports prepared for or submitted 

11 to Adaptec's senior management on a periodic basis, including, but 

12 not limited to, operating reports, projections, sales reports or 

13 forecasts, or comparison of results to budget or plan. 

14 REQUEST NO. 50 : 

15 All documents submitted to any cf the following: 

16 (a) Bank of America, NT&SA; 

17 (b) Moody's Corp.; 

18 (c) Standard & Poor's Corp.; and 

19 (d) Barron's 

20 REQUEST NO. 51 : 

21 All Adaptec financial statements for the fiscal years April 

22 1, 1989 to March 31, 1990 ("fiscal 1990"), and April 1, 1990 to 

23 March 31, 1991 ("fiscal 1991"), and interim quarters thereof, and 

24 all documents which constitute, evidence or refer to the 

25 preparation or publication of all such statements, including, but 

26 not limited to, workpapers and any analyses. 
27 

28 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 13 - 



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REQUEST NO. 52: 

All documents which constitute, evidence or refer to financial 
plans, targets, projections, budgets or forecasts of financial 
results of Adaptec. 

REQUEST NO. 53: 

All documents that record, discuss or refer to variances 
between Adaptec's planned, targeted, budgeted or forecasted 
financial or operational results and its actual results. 
REQUEST NO. 54 : 

All documents which constitute, evidence or refer to Adaptec's 
revenue recognition policies, including, but not limited to, 
Adaptec's revenue recognition policy manuals, drafts thereof, and 
all supplements thereto used or in effect during any portion of the 
period January 1, 1989 through present. 

REQUEST NO. 55: 

Adaptec's Corporate Policy Manuals and all supplements and 
amendments, including replaced pages and sections used or in effect 
during any portion of the period January 1, 1989 through present. 

REQUEST NO. 56: 

Adaptec's sales practice manuals and all supplements and 
amendments used in the United States, in Singapore, in Germany 
and/or in Belgium. 



23 REQUEST NO. 57: 



All financial planning manuals used in the United States, in 
Singapore, in Germany and/or in Belgium. 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 14 



210 



1 REQUEST NO. 58: 

2 All internal audit reports relating to each of the following 

3 subjects: 

4 (a) revenue recognition; 

5 (b) trades receivables ; 

6 (c) reserves for uncollectible trade receivables or 

7 allowances and provisions for doubtful accounts; 

8 (d) customer advances and unearned revenues; 

9 (e) financial applications software; 

10 (f) sales commitments or deliverables or sales quotas; 

11 (g) deferred receivables; 

12 (h) prepay contracts; 

13 (i) credit acquisition plan; 

14 (j) foreign currency transactions; 

15 (k) accrued liabilities; 

16 (1) technical support; and 

17 (m) FASB required accounting policies. 

18 REQUEST NO. 59 : 

19 All documents relating to Adaptec's practices in closing a 

20 quarter, including leaving it open for a certain number of days, 

21 after the calendar date close, e.g., June 30th, September 30th, 

22 December 31st, or March 31st. 

23 REQUEST NO. 60 : 

24 All documents relating to each of the subjects listed in 

25 Request 58 through 60 hereof, authored by the internal audit 

26 department, other than the audit reports and all responses or 

27 communications with the internal audit department relating to same. 



28 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 15 



211 



1 REQUEST SSL 61 = 

2 All documents reflecting meetings of the internal audit 

3 departaent with the Adaptec Board Audit Committee and all 

4 communications between them. 

5 BEQUEST NO. 62: 

6 All documents which constitute, evidence or refer to 

7 Adaptec ' s : 

8 (a) quarterly sales cutoff procedures; 

9 (b) increases in trade receivables ; 

10 (c) unbi liable trade receivables ; 

11 (d) the validity and collectibility of trade receivables; 

12 (e) reserves for uncollectible receivables or allowances and 

13 provisions for doubtful accounts; 

14 (f) customer advances and unearned revenues; 

15 I (g) financial applications and software; 

16 (h) deferred receivables; and 

17 (i) prepaid contracts. 

18 REQUEST NO. 63: 

19 All documents which identify the names and addresses of 

20 members of Adaptec's sales force who have been terminated by 

21 Adaptec since January 1, 1990. 

22 REQUEST NO. 64: 

23 All management letters for fiscal 1988, 1989 and 1990, 

24 received from or discussed with Arthur Andersen t Co. or any of its 

25 institutional affiliates, and all documents reflecting Adaptec's 

26 responses or actions in response thereto. 
27 

28 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 16 - 



212 



1 I REQUEST NO. 65 : 

2 I All documents received from Arthur Andersen & Co. reflecting 

3 | or referring in whole or in part to Adaptec's Management 

4 | Information Systems or to each of the following subjects: 

5 | Consolidated Balance Sheet Items 

6 Trade receivables 

7 Allowance and provisions for doubtful accounts 

8 Accrued compensation and related benefits 

9 Accrued liabilities 

10 Customer advances and unearned revenues 

11 Foreign currency translations 

12 Consolidated Statements of Income 

13 Revenues, including license revenue and service revenues 

14 Sales and marketing expenses 

15 Cost of service expenses 

16 Consolidated Statements of Cash Flow 

17 Provisions for doubtful accounts 

18 Increase in receivables 

19 Increase in other accrued liabilities 

20 | Increase in customer advances and unearned revenues 

21 Notes to financial statement relating to the following 

22 subjects as reflected in the notes: 

23 Revenue recognition 

24 Unbilled revenues 

25 Foreign currency translation 

26 Stock option plan 
27 

28 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 17 - 



1 



213 



Deferred taxes relating to timing differences in the 



2 I recognition of revenues and expenses for tax and 

3 financial statement purposes 

4 Segment information 

5 Litigation 

6 I REQUEST NO. 66: 

7 I Reports, whether financial or otherwise, prepared by or for 

8 | Arthur Andersen on Adaptec. 

9 REQUEST NO. 67 : 

10 Documents given or shown by Adaptec to its internal or outside 

11 auditors or received by the Company from its internal or outside 

12 auditors relating, in whole or in part, or referring to Adaptec's 

13 internal accounting and management controls, including, but not 

14 limited to, those relating to recognition of revenues, orders, 

15 sales, terms of sales, sales returns, discounts, allowances, trade- 

16 ins, earnings, adjustment to financial statements, internal or 

17 external investigations, press releases or public statements, 

18 financial or accounting policy or practice, compliance with any 

19 financial or accounting policy cr practice, restatement of results, 

20 inventory or receivables reserve or allowance, inventory or 

21 receivable writeoff or writedown, illegal act or capitalization of 

22 development costs, sales cutoff procedures, trade receivables, 

23 | unbillable trade receivables, reserves for collectible receivables. 



24 

25 
26 
27 
28 



sales personnel, contracts with customers, and forecasting of 
Adaptec's performance and prospects. 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 18 - 



214 



1 REQUEST NO. 68; 

2 Communications between Arthur Andersen & Co. with the Board 

3 of Directors of Adaptec or any committee thereof, including the 

4 Audit Committee, concerning the business, financial condition or 

5 I actual or projected results of operations of Adaptec. 

6 REQUEST NO. 69; 

7 Documents relating to or referring to any disagreement or 

8 difference of opinion on the part of Adaptec with the conclusions 

9 or recommendations contained in any report, financial statement or 

10 other document prepared by or for Arthur Andersen in connection 

11 with its engagement by Adaptec. 

12 REQUEST NO. 70 : 

13 Documents relating to the financial books and records of 

14 Adaptec being kept open after the close of the fiscal year or for 

15 interim quarters thereof for a certain number of days. 

16 REQUEST NO. 71; 

17 If not produced in response to a prior request, all contracts 

18 with respect to which revenue was in fact recognized in the quarter 

19 for each of interim quarters ended March 31, 1989 through present. 

20 REQUEST NO. 72; 

21 I All documents which constitute, evidence or refer to sales 

22 | quotas for Adaptec's sales force. 

23 I REQUEST NO. 73; 

24 | All documents relating to the practices and terms of 
2 5 compensating sales personnel, sales managers, and executive vice 
26 presidents in charge of sales. 
27 

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PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 19 - 



215 



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REQUEST NO. 74: 



All documents relating to business or proposed business by 

Adaptec with each of the following: 

(a) Conner Peripherals, Inc. 

(b) IBM 

(c) Digital Equipment Corporation 

(d) Epson America 

(e) Hewlett-Packard 

(f) Seagate Technology, Inc. 

10 | (g) Sony Corporation 

11 I (h) Tandy Corporation 

12 I (i) Toshiba Corporation 

13 J (j) Unisys Corporation 

14 | (k) Hitachi 

1 5 I (1) Miniscribe Corporation 

16 | (m) Quantum Corporation 

17 I (n) Intel 

18 I (o) Nokia 

19 | (P) NEC 

20 J (q) Fujitsu 
(r) Microsoft 
(s) Apple Computer 

REQUEST NO. 7S : 

All documents which constitute, evidence or refer to the terms 
and conditions of sale extended to customers of Adaptec, including 
provisional sales and extended payment terms. 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 20 



216 



1 I REQUEST NO. 76: 

2 All documents which discuss or refer to any deviation from the 

3 Company's standard terms for payment of invoices by customers. 

4 REQUEST NO. 77: 

5 All documents which evidence or refer to the availability of 

6 technical support, technical assistance, and/or backup to Adaptec's 

7 customers . 

8 REQUEST NO. 78: 

9 All documents which constitute, evidence or refer to buys in, 

10 delivery schedules for, availability of, delays, customer 

11 complaints, and the amount cf orders and backlogs of Adaptec 

12 products. 

13 REQUEST NO. 79 : 

14 All documents relating to or referring to Adaptec's practices 

15 for monitoring its contracts with customers. 

16 REQUEST NO. 80 : 

17 All documents relating to or referring to Adaptec's practices 

18 for monitoring sales personnel. 

19 REQUEST NO. 81 : 

2 All documents which evidence or refer to any statements by 

21 Adaptec that SCSI is becoming the "accepted industry standard 

22 interface" or that SCSI had become ar. American National Standards 

23 Institute Standard Interface. 

24 REQUEST NO. 82: 

25 All documents describing, discussing, referring to or prepared 

26 in connection with any member of the professional investment 
2 7 community, including underwriters, dealers, analysts, investment 



28 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 21 - 



217 



1 advisors, brokerage houses and investment brokers and Adaptec on 

2 or about the following dates: 

3 (a) September 29, 1989; 

4 (b) October 13, 1989; 

5 (c) June 27, 1990; 

6 (d) August 9, 1990; 

7 (e) August 21, 1990; 

8 (f) September 10, 1990; 

9 (g) October 8, 1990; 

10 (h) October 12, 1990; and 

11 | (i) October 15, 1990. 

12 I REQUEST NO. 83 : 

13 I All documents referring or relating to Adaptec's decision 

14 I regarding a one time breakdown of nonconforming material. 

15 REQUEST NO. 84 : 

16 All documents referring to or relating to creation of an 

17 1 inventory reserve due to accelerating industry transition to 

18 I embedded controller solutions relating to Adaptec's older AT 

19 | controllers. 

20 REQUEST NO. 85; 

21 I All documents which constitute, evidence or refer to the 

22 | company's claim that through effective working capital management 

23 I Adaptec has increased their cash balance to $56 million. 

24 I REQUEST NO. 86; 

25 I All documents describing, discussing, referring to or prepared 

26 | in connection with defendant Adler's appearance at the Computer 
Services and Communications and Information Systems Seminar 



27 
28 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 22 



218 



1 relating specifically, but not limited to defendant Adler's 

2 statements that: 

3 (a) Adaptec would soon be on the Forbes 200 list of companies 

4 | with revenues between $50 and $100 million; 

5 (b) Adaptec is expected to experience "tremendous growth" and 

6 coming quarters would be "very, very good for us"; 

7 (c) The Adaptec market "is projected to grow very, very 

8 fast," and the company operated in a "very healthy, fast growing 

9 market" ; 

10 (d) "If we execute correctly, and we have, you're going to 

11 see us continue to grow very fast"; and 

12 (e) The company's R&D costs were expensed and thus would not 

13 be recognized in future periods leading the company to have a 

14 "whistle clean" balance sheet. 

15 REQUEST NO. 87 : 

16 All documents describing, discussing, referring to or prepared 

17 in connection with Adaptec's December 10, 1990 press conference 

18 wherein the Company announced that earnings would be significantly 

19 lower than expected due to a "sales shortage" due to a general 

20 economic slowdown and slumping demand among Adaptec's customers, 

21 and also due to new produce delays and a decline in demand for 

22 older products. 

23 REQUEST NO. 88 : 

2 4 All documents prepared by any internal audit personnel of the 

25 Company or by any person charged with responsibility for performing 

26 an internal audit function relating, in whole or in part, to 

27 orders, sales, terms of sales, sales returns, discounts, 
28 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS 



23 



219 



1 U allowances, trade-ins, earnings, adjustment to financial 

2 | statements, internal or external investigations, press releases or 

3 | public statements, financial or accounting policy or practice, 

4 J compliance with any financial or accounting policy or practice, 
system of internal financial or accounting policy or practice, 
system of internal financial or accounting controls, restatement 
of results, inventory or receivable reserve or allowance, inventory 
or receivable writeoff or writedown, illegal act, or capitalization 
of software development costs. 

REQUEST NO. 89 : 

All documents prepared or received by you in connection with 
any audit or review of Adaptec financial statements. 
REQUEST NO. 90 : 

All documents which discuss cr refer to any review or audit, 
whether by internal or outside auditors, of Adaptec's financial 
statements or records. 

REQUEST NO. 91 : 

All documents which discuss or refer to any proposed or actual 
restatement of any component of any Adaptec financial statements. 
REQUEST NO. 92 : 

All documents that constitute, discuss or refer to sales or 
orders in general. 

REQUEST NO. 93 : 

All documents that constitute, discuss or refer to orders 
backlog or analysis of any orders backlog. 



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PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 24 - 



220 



1 REQUEST NO. 94 ; 

2 All documents which contain, refer to or discuss any review 

3 or investigation of sales or orders or of any accounting treatment 

4 of sales or orders. 

5 REQUEST NO. 95 : 

6 All documents which refer to or discuss Adaptec's policy or 

7 procedure for recording sales on the Company's financial statements 

8 or books or records. 

9 REQUEST NO. 96 : 

10 All documents which constitute, discuss or refer to Company 

11 policies or procedures for shipping product pursuant to an order. 

12 REQUEST NO. 97 : 

13 All documents which constitute, discuss or refer to any 

14 shipment of NET products without a valid underlying order. 

15 REQUEST NO. 98 : 

16 All documents which constitute, discuss or refer to any 

17 discount, allowance or trade-in given or permitted in connection 

18 with the sale of any Adaptec product or service. 

19 REQUEST NO. 99 : 

20 All documents that show, refer to or discuss commissions paid 

21 to salespersons by Adaptec. 

22 REQUEST NO. 100 : 

23 All Adaptec sales registers or journals. 

24 REQUEST NO. 101 : 

2 5 The stock transfer records of Adaptec during the relevant 

26 period. 

27 

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PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 25 - 



221 



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REQUEST NO. 102: 

All documents that discuss, refer to, or contain information 
about the Company's accounts receivable and/or payment terms for 
Adaptec's products. 
REQUEST NO. 103 : 

All documents that discuss or refer to profit margins at 
Adaptec . 

REQUEST NO. 104: 

All documents contained in any of Adaptec's customer files. 

REQUEST NO. 105 : 

All purchase orders, sales orders, invoices, shipping records, 

payment records, return records and receiving records, for any 

Adaptec product or service. 

DATE: March 27, 1991 

MILBERG WEISS BERSHAD 

SPECTHRIE & LERACH 
WILLIAM S. LERACH 
ALAN SCHULMAN 
DANIEL J. MOGIN 
ELLEN A. GUSIKOFF 



fdoL ScU*/C 



DANIEL J. MOGIN 

225 Broadway, Suite 2000 
San Diego, CA 92101 
Telephone: 619/231-1058 



PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS 



26 



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1 EUGENE A. SPECTOR & ASSOCIATES 

EUGENE A. SPECTOR 

2 15th & Locust Streets 

Lewis Tower Bldg, Suite 624 

3 Philadelphia, PA 19102 

Telephone: 215/545-5335 

4 

I ABBEY 6 ELLIS 

ARTHUR N. ABBEY 
212 East 39th Street 
New York, NY 10016 
Telephone: 212/889-3700 
7 

BERGER 6 MONTAGUE, P.C. 

8 SHERRIE R. SAVETT 

JEAN MARKEY 

9 1622 Locust Street 

Philadelphia, PA 19103 . 

10 Telephone: 215/875-3000 

11 KAPLAN & KILSHEIMER 

ROBERT N. KAPLAN 

12 685 Third Avenue, 26th Floor 

New York, NY 10017 

13 Telephone: 212/687-1980 

14 LAW OFFICES OF 

I. STEPHEN RABIN 

15 I. STEPHEN RABIN 

685 Third Avenue, 26th Floor 

16 New York, NY 10017 

Telephone: 212/682-1818 

17 

SCHIFFRIN & CRAIG, LTD. 

18 RICHARD SCHIFFRIN 

2020 North Halsted Street 

19 Chicago, IL 60614 



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Telephone: 312/528-6646 
Attorneys for Plaintiffs 



*DAMCC\DSS01U8.liEO 

PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO 
DEFENDANT ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS - 27 



223 



1 DECLARATION OF SERVICE BY FEDERAL EXPRESS 

2 

3 I, the undersigned, declare: 

4 1. That declarant is and was, at all times herein mentioned, 

5 a citizen of the United States and a resident of the County of San 

6 Diego, over the age of eighteen (18) years, and not a party to or 

7 interested in the within action; that declarant's business address 

8 is 225 Broadway, Suite 2000, San Diego, California 92101. 

9 2. That on March 27, 1991, declarant caused true copies of 

10 PLAINTIFFS' FIRST REQUEST FOR PRODUCTION OF DOCUMENTS TO DEFENDANT 

11 ADAPTEC, INC. AND THE INDIVIDUAL DEFENDANTS to be delivered to 

12 Federal Express for service on each of the parties listed on the 

13 attached Service List on March 28, 19C>1. 

14 I declare under penalty of perjury that the foregoing is true 

15 and correct. 

16 Executed this 27th day of March, 1991, at San Diego, 

17 California. 
18 
19 " VICKI^LJ ANDREWS 

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224 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOMENICI 

FROM JOHN G. ABLER 

We received a letter from Don Riegle, Chairman regarding testi- 
mony given by John G. Adler, Chairman of the Board and CEO of 
Adaptec, Inc. relating to testimony made by Bill Lerach to the Se- 
curities Subcommittee hearing on private litigation under Federal 
Securities Laws. At your request, the response format repeats the 
questions asked, then provides an answer. 

Q.l. Reply to the assertion that the current versions of Rule 11 and 
Rule 9(b) of the Federal Rules of Civil Procedure provide sufficient 
protection against meritless suits. 

A.1. Rule 11 and Rule 9(b) do not provide sufficient protection 
against meritless suits. Securities laws cast a broad net in an at- 
tempt to cover a wide variety of actions, and at the same time 
make access to the courts as easy as possible. 

Once a suit is filed, the Federal Rules of Civil Procedure, as in- 
terpreted by the United States Supreme Court, require that courts 
can not dismiss a claim "unless it appears beyond doubt that the 
plaintiff can prove no set of facts in support of 'his claim which 
would entitle him to relief." (emphasis added) It is unreasonable to 
expect that a court, in the beginning of complex litigation, would 
presuppose that no set of facts could possibly exist which could 
support a claim. When the broad net cast by the securities laws is 
added to the virtually unlimited hypothetical realm that must be 
eliminated before a case can be dismissed, dismissal rarely occurs. 

Unless a case is dismissed at the outset, plaintiffs can ask for 
virtually any and all documentation produced by a company over 
extended periods of time. Rules 11 and 9(b) provide the judge with 
ammunition only against "frivolous" motions and claims. Just as a 
court will not dismiss a claim unless there is no possibility that a 
claim could exist, similarly courts often cannot award sanctions 
against the "fishing expedition" allowed by discovery rules, espe- 
cially when read in conjunction with the broad mandate of the se- 
curities laws. Many innocent companies like Adaptec are forced 
into an untenable position of having to expend an immense amount 
of funds in response to virtually unlimited discovery claims, and di- 
vert extensive management time and "mind share," all without re- 
course and without opportunity for restitution. In this manner the 
Federal Rules of Civil Procedure are very ineffectual in practice to 
discourage meritless suits. 

Q.2. Posits several changes to Rule 11 which would weaken the ef- 
fect of sanctions, including barring an award of sanctions if the 
challenged pleading is withdrawn within twenty-one days of service 
of a motion for sanctions. 

A.2. The proposed changes in Rule 11 weaken its status and pro- 
vide even less protection against meritless suits. Merely eliminating 
sanctions if a pleading is withdrawn (twenty-one days after a mo- 
tion for sanctions has been filed) presupposes that the recipient of 
the frivolous pleading does nothing in the intervening twenty-one 
days. It presupposes that the motion for sanctions is filed before 
the innocent party has gone through the time and expense of re- 
sponding to the pleading. Because very few companies can rely 
upon the grant of sanctions, and the response dates for the plead.- 



225 

ing is not automatically forestalled pending judgment on sanctions, 
companies must respond immediately regardless of whether or not 
the pleading is frivolous. By eliminating the guarantee of sanc- 
tions, recipients of frivolous pleadings have no chance of recovering 
sunk cost and time required to respond to the pleading. 

Moreover, denying sanctions merely if the frivolous pleading is 
withdrawn ignores the fact that the innocent party had to spend 
time and expense to prepare the motion for sanctions itself. We be- 
lieve any proposed changes in the law, should be subject to an "in- 
nocent party test" and assume that an innocent party is thrown 
into the system. This hypothesis would demonstrate the advan- 
tages and/or disadvantages to the vast majority of companies cur- 
rently being harassed by these meritless suits. 

Q.3. How much did it cost Adaptec in legal fees? 
A.3. Assuming "it" constitutes legal defense costs for the suit, from 
the date of filing through written discovery only, Adaptec expended 
$1.8 million dollars in legal fees, a portion of which will be reim- 
bursed from insurance coverage under our D&O insurance. How- 
ever, Adaptec also was forced to expend internal resources, includ- 
ing management time and engineering time, and incur lost oppor- 
tunity costs. Any review of the costs of these suits should also re- 
flect these "soft" costs as well. 

We hope this clarifies the untenable position into which many in- 
nocent companies are thrown as a result of the interaction between 
current securities laws and the Federal rules of Civil Procedure. 
Please do not hesitate to contact me if you have any additional 
comments or questions, or if I may be of any additional service in 
any way. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SASSER 

FROM RICHARD J. EGAN 

Dear Senator Riegle, my thanks to you and Senator Sasser for 
providing me with this opportunity to give my views on what I 
strongly believe to be the abuse and frivolous actions being per- 
petrated by Plaintiff Law Firms and professional Plaintiffs in many 
of today's securities related Class Action Suits. 

Legislative changes are definitely required and I am pleased to 
honor your request for applicable recommendations. With so much 
going on (e.g., the Budget and Proposed Tax legislation), I am par- 
ticularly impressed with and grateful for the apparent sincere in- 
terest this matter is receiving. 

Q.l. There have been growing complaints about the "litigation ex- 
plosion," particularly against high-technology companies. One of 
the explanations offered to explain the high incidence of securities 
fraud cases filed against high-tech firms is that they tend to be 
volatile on the stock market, and that investors sue the companies 
in order to recoup their losses, whether or not there has been 
fraud. Moreover, even if there is no fraud, there is an incentive for 
the company to settle out of court to avoid the cost of litigation. 

Is this really happening? If so, does the law governing private se- 
curities litigation play a role? How could it be reformed to continue 
to protect investors against genuine fraud while also curtailing friv- 
olous lawsuits? 



226 

A.1. 1 regret to say that the frequency and severity of securities re- 
lated class-action suits is really happening. In the case of EMC 
Corporation, two occurred within the last five years. Unfortunately 
the law governing private securities litigation does not play the 
role needed. These lawsuits usually occur immediately (sometimes 
within hours) after the company's stock price precipitously declines 
by 10 percent or more. The strike suit is filed so quickly that it is 
impossible for the "Plaintiffs" to determine if any fraud has been 
committed. Yet their word processor generated filing always claims, 
without specificity, that there was fraud. The ensuing litigation 
process then consumes the company and management's time and 
money through endless depositions, interrogatories and addressing 
the concerns of Shareholder, Customers, Employees, and Vendors. 
Legislation is needed to level the playing field in this game. We 
have given considerable thought to this matter and have recently 
suggested the following reforms would help to balance the class-ac- 
tion litigation process. There is little in these suggestions which 
would limit investors' rights. They are as follows: 

I. To provide some reasonableness of the claim 

a. There should be a standard of "clear and convincing" proof of 
allegations of fraud against companies. This would discourage law- 
suits based upon statements of a company that turned out to be in- 
accurate, but that were not intended to mislead investors or the 
public. 

b. Establish the SEC's role to review all 10(b)(5) complaints be- 
fore they are actually filed. I believe this could be made self-funded 
from fees paid by the participants. 

c. Implement a perpetual "statutory offer of judgment." Once a 
class-action suit has begun, it goes on endlessly. By allowing either 
party the opportunity to settle the matter at any time under the 
terms of Rule 68 should promote reasonableness. 

d. Require that all 10(b)(5) cases be submitted to Alternative Dis- 
pute Resolution (ADR). 

e. Perhaps some combination of (c) and (d). 

II. Discourage Professional Plaintiffs 

a. Plaintiffs should not be "invisible." They should be made to ap- 
pear immediately and should not be allowed to become "profes- 
sional," that is appear as Plaintiffs in lawsuit after lawsuit. 

b. Contracts, arrangements, and relationships with other plain- 
tiffs and their respective law firms should be made discoverable. 

III. To discourage the Plaintiffs Bar for "creating" 
unnecessary lawsuits 

a. The American Bar Association should be urged to track and 
investigate law firms that engage in repeated Strike Suits and to 
establish criteria for defining and publicly identifying those firms 
that repeatedly file frivolous suits. 

Q.2. Critics argue that frivolous litigation is time-consuming and 
distracts chief executives and other corporate officials from produc- 
tive economic activity. They also argue that securities litigation 
seeks huge monetary recoveries from outside directors, outside law- 



227 

yers and independent accountants, who may be only marginally in- 
volved in fraudulent activity for which a corporation should be pri- 
marily liable. 

How does litigation, or the threat of litigation, effect your busi- 
ness? In particular, has private securities fraud litigation impaired 
your ability to raise capital? Have you encountered difficulty at- 
tracting qualified persons to serve on your board of directors? Are 
accounting firms willing to audit your books? 

A.2. The two instances of securities related litigation aforemen- 
tioned affected EMC Corporation greatly. In the first instance we 
were a very small company and it preoccupied almost all of us. The 
fear that this lawsuit would wipe us out compelled me to pay off 
the Plaintiffs' lawyers — a matter I regret to this day. In the second 
instance, we had the courage and fortitude to fight it and we won. 
The judge in this case had the time and patience to weed through 
all of the accusations and innuendoes and declared finally that the 
case was "dead on arrival." So in these instances it cost us enor- 
mous time and money and the attendant publicity cost us sales as 
well. The latter case, dragged out through a period in which we 
found it necessary to raise equity capital. During this effort the 
number of questions devoted exclusively to "Our Lawsuit" were nu- 
merous. Although I can't prove it, I am certain it cost the company 
and existing shareholders a few million dollars because of the con- 
cern the many shareholders had about the possible adverse out- 
come. 

Yes, we have had difficulty attracting and retaining qualified 
Board Members. Specifically, we have had two Board Members re- 
sign their positions as a result of these lawsuits. We don't have 
D&O Insurance for we feel that this would further attract strike 
suits. I can't say that we have had difficulty employing accounting 
firms. 

Q.3. Some of the criticisms of the current system may not be mutu- 
ally exclusive. Indeed, while critics of the current system argue 
that steps should be taken to curb litigation, others have argued 
that other steps should be taken to facilitate investor lawsuits, 
such as lengthening the statute of limitations for securities fraud. 
Are these two criticisms of the current system mutually exclu- 
sive? Or, should securities litigation reform and lengthening the 
statute of limitations be considered together? 

A.3. Our major criticism is that these strike suits are abusive and 
frivolous. As previously mentioned, they are filed often in a matter 
of hours after the stock drops and then the Plaintiffs' attorneys try 
to find something that may have induced their client's to buy or 
sell the stock. (Most of these Plaintiffs are professionals that lend 
their name to the suits over and over again.) Essentially, these 
suits are without basis precipitated by the lawyers and they hap- 
pen quickly, hence the term strike suit. Therefore, legislation 
lengthening the statute of limitations should not affect our main 
concern although I really can't see any reason for doing it. 



228 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR BRYAN 

FROM RICHARD J. EGAN 

Q.l. On page 69 of the transcript, you state that, if a judge deter- 
mines a suit to be a class action, "we the companies have to adver- 
tise for plaintiffs to join the plaintiffs' law firm." Please explain 
what you mean by this statement. How are companies forced to ad- 
vertise? 

A.1. Rule 23(c)(2) of the Federal Rules of Civil Procedure requires 
that notice be given to members of the class of the pendency of a 
class action once the judge determines that the action may proceed 
as a class action. It requires the "best notice practicable under the 
circumstances." Courts have uniformly interpreted this to require 
an advertisement to be placed in newspapers of national circulation 
such as the Wall Street Journal. This requires an ad (usually in 
black-bordered tombstone format) notifying all readers that a class 
action has been certified and giving the company name, the name 
of the case, a brief description of the type of allegations made, iden- 
tity of each defendant, and the name, address and phone numbers 
of plaintiffs' law firm so that anyone who believes he may be a 
member of the class may contact the plaintiffs' law firm. 

In addition, the same rule of procedure requires that once a 
judge determines a suit to be a class action, the company must pro- 
vide the company's stockholder name and address list to plaintiffs 
counsel who then mails an individual notice of the class action to 
every stockholder during the class period. The notice includes the 
plaintiff law firm name, address and phone number stating that 
questions should be directed to plaintiffs law firm. 

Furthermore, once the plaintiffs law firm has the address list, it 
can communicate with the company's stockholders directly and the 
company is forbidden to find out anything about those communica- 
tions. 

In any settlement of the class action, the full cost of all these 
various types of notice to the class (including the advertisement) is 
submitted to court by the plaintiffs' law firm for payment by the 
company. 

Q.2. In response to a question from Senator Dodd, you state that 
Rule 11 motions to sanction plaintiffs' attorneys are not enforced. 
You state that "the judges will just let the motions go on and on." 
What is the basis for this statement? Please provide all information 
and materials bearing on this issue to the Subcommittee. 

AJ2. In EMC's own recent experience, a securities class-action case 
entitled, Joseph A. Tapogna, et al. v. Richard J. Egan, et al., Civ. 
No. 91-11873-S (D. Mass. 1992), the magistrate-judge, to whom 
EMC's motion to dismiss the case was referred for recommenda- 
tion, recommended that the case be dismissed and that Rule 11 
sanctions be imposed and costs awarded against plaintiffs' attor- 
neys for bringing suit without basis against one of the company^ 
co-founders. The magistrate-judge's lengthy, reasoned decision is 
enclosed for inclusion in the record. The judge reviewing the mag- 
istrate-judge's decision dismissed the baseless suit as recommended 
but, without significant explanation, declined to follow the mag- 
istrate's recommendation that Rule 11 costs be imposed on plain- 



229 

tiffs' law firm as sanction. EMC was, therefore, required to pay the 
expense of defending against a demonstrably baseless suit. 

I am informed that Kule 11 sanctions have rarely been imposed 
in connection with dismissals of securities class actions even where 
the court finds under Rule 9 that there were no facts alleged upon 
which a claim of fraud could have been based. 

We remain very impressed with the diligence and thoroughness 
that the Committee and Staff are investigating this matter. Please 
feel free to contact me at any time. 



230 



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[H 96,636] Tapogna, e* al. v. Egan, et al. 

United States District Court. District of Massachusetts. CIVIL ACTION NO. 91-11873-S. 
Magistrate Judge's. Reports and Recommendations of January 31, 1992 in full text; District Judge's 
Opinion of March 17,* 1$92. in full text. 

1. Exchange Act— Antifraud — Companies — Officers — Pleadings — Particularity.— Stock 
purchasers failed to adequately particularize their Section 10(b) claim that a company, through its 
officers, made false and misleading statements and omissions. There were no allegations of specific 
facts tending to show: that the defendants knew that optimistic projections were false when made. 
Further, certain defendants' personal sales of stock began well before the deterioration of the 
company's prospects. 'Standing alone, the fact that the sales occurred did not support an inference of 
fraud. 

See f 2272I and 22,725, "Exchange Act — Manipulations; National Market "System" division, 
Volume 3. ... 

2. Exchange Act — Controlling Person Liability — Sanctions. — FRCP 11 sanctions were 
not imposed upon investors for naming a former corporate officer and director as a defendant based 
on their theory that his ownership of over 10% of the corporation's outstanding stock gave rise to his 
status as a "controlling person" under Section 20(a). The defendant's contention, that he no longer 
was an officer, or a director of the corporation at the time he sold his stock was not relevant to the 
issue of whether he was a controlling person under the 1934 Act. 

See f 26,311, "Exchange Act — Insiders; Recordkeeping, Clearance & Transfer" division. Vol- 
ume 4. 



Opinion of COLUNGS, U.S. Magistrate Judge. 

REPORT AND RECOMMENDATION ON 

MOTION TO DISMISS THE FIRST 

AMENDED COMPLAINT (/ 18) 

INTRODUCTION 

The instant securities action was instituted 
on July 15, 1991. In lieu of answering the origi- 
nal complaint, the four named defendants, Rich- 
ard J. Egan, Michael C. Ruettgers, Roger M. 
Marino and EMC Corporation filed a motion to 
dismiss. On the same date that the opposition to 
the motion to dismiss was filed, plaintiffs Joseph 
A. Tapogna and William E. Pommerening, 
amended their complaint as of right. This 
change in the pleadings prompted the defend- 
ants to file a motion to dismiss the first 
amended complaint in response to which an 
opposition was duly filed. 

All four defendants are named in each of the 
three counts of the first amended complaint. 
Count I is a claim for violation of the federal 
securities laws, specifically section 10(b) of the 
Securities and Exchange Act of 1934 and Rule 
10b-5 promulgated thereunder. Counts II and 
III are claims under Massachusetts common 
law, i.e., fraud and negligent misrepresentation 
respectively. The grounds for the motion to dis- 
miss are failure to plead fraud with particular- 
ity as required by Rule 9<b), Fed.R.Civ.P., and 
failure to state a claim upon which relief can be 
granted under Rule 12(b)(6). Fed.R.Civ.P; 

The defendants' dispositive motion has been 
referred to the undersigned for the issuance of 
findings and recommendations as to disposition 
pursuant to 28 U.S.C. §636(bXlXB). The par- 
ties have briefed the issues raised in various 
memoranda of law, and oral argument was 

Federal Securities Law Reports 



heard in the latter part of December. With the 
record now complete, the motion to dismiss the 
first amended complaint is ripe for decision. 

THE FACTS 

The factual background of this case as recited 
is gleaned from the material allegations of the 
first amended complaint which are accepted as 
true. Ussier v. Little, 857 F.2d 866. 867 (1 Cir., 
1988), cert, denied, 489 U.S. 1016 (1989); Wil- 
liams v. Citv of Boston, 784 F.2d 430, 433 
(1986). On April 19, 1991. plaintiff Joseph A. 
Tapogna ("Tapogna") purchased 1,000 shares of 
the common stock of EMC Corporation 
("EMC"). (First Amended Complaint #13, para 
5a) On the same date, William E. Pommerening 
("Pommerening") bought 750 shares of the com- 
mon stock of EMC jointly with his wife. (#13, 
para. 5b) Tapogna and Pommerening purport to 
bring this suit as a class action, seeking to re- 
present all those who purchased the common 
stock of EMC during the period from September 
24. 1990 through July 11. 1991. (#13, para. 13) 

EMC is a Massachusetts corporation with a 
principal place of business in the Common- 
wealth. (#13, para. 6) EMC is engaged in the 
design, manufacture and marketing of high per- 
formance storage products and related services 
for certain mid-range and mainframe computer 
systems. (Id.) Defendant Richard J. Egan 
("Egan"), co-founder of EMC, has served as a 
director and the Chief Executive Officer of the 
company as well as, since January 1988, holding 
the position of Chairman. (#13, para. 7) It is 
alleged that Egan owned over ten percent of the 
stock of EMC during the time period relevant to 
the amended complaint. (#13, para. 8) 

Defendant Roger M. Marino ("Marino") was 
also a co-founder of EMC. (#13, para. 8) Al- 

H 96,636 



231 



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1504 5-27-92 



though Marino served as Treasurer, Vice-Chair- 
man and a .director of the company, he resigned 
from the first two positions in July of 1990, and 
then as a director in January, 1991. (Id.) Like 
Egan, Marino is alleged to have owned over ten 
percent of EMC's stock during the pertinent 
time.period. (Id.) The third individually name 
defendant, Michael C. Ruettgers ("Ruettgers") 
is .the President, and Chief Operating Officer of 

The gist of the first 'amended complaint is 
that the defendants conspired to issue and dis- 
seminate materially false and misleading repre- 
sentations and public statements so as 
artificially to inflate, and maintain the market 
price of EMCs common ?tock to the detriment 
of stock purchasers. </13, para. 10, 20) Tapogna 
and Pommerening contend that the representa- 
tions and statements, which shall be detailed 
hereinafter',' were "materially false and mislead- 
ing and/or recklessly made due to the existence 
of material,' undisclosed, adverse facts about 
EMC and its operations. (#13, para. 20) 

The positive and optimistic statements made 
to the investing public about which the plain- 
tiffs complain are as follows. On or about Sep- 
tember 24 and 25, 1990, it was reported in 
publications such as Reuters, Business Wire, 
and The Boston Globe that EMC would soon be 
introducing its next generation data storage 
technology called Symmetrix. (#13, para. 22) 
According to Reuttgers, sales from Symmetrix 
were expected to add significantly to fourth 
quarter revenues in 1990, up to as much as $100 
million, and that 1991 revenues could be be- 
tween $200 and $300 million. (Id.) The Com- 
pany forecast that Symmetrix sales would 
increase "dramatically" in 1992 as the product 
line expanded and the technology became more 
familiar. (Id.) 

EMC announced its third quarter 1990 earn- 
ings on or about October 22, 1990. (#13, para. 
23) Revenues reflected a 23 percent increase 
over those reported for the third quarter 1989 
with a net income increase equal to 10 cents a 
share as against a loss for the same quarter the 
prior year. (Id.) For the nine month period end- 
ing September 30, 1990, revenues were reported 
in excess of $124 million with a net income 
equalling 22 cents per share as compared to 
revenues of $92 million and a loss of more than 
$11 million for the corresponding 1989 nine 
month period. (Id.) In a Business Wire article 
reporting EMC's third quarter figures, Egan 
was quoted as being "very pleased with the 
results in the third quarter and for the year to 
date. This is especially true since we seem to be 
swimming against the prevailing economic 
tide." (#13, para. 24) 

On November 13, 1990, EMC announced the 
introduction of an additional model to its Sym- 
metrix series. (#13, para. 25) Egan stated that 
"Symmetrix will have a major impact not only 

1196,636 



on the computer industry but .also on the busi- 
ness community" by enabling companies '.'to gel 
vital information more quickly, while extending 
computer life and containing computer costs." 
(Id.) According to Egan, EMC was able to intro- 
duce its version of Redundantv Arrays Of Inex- 
pensive Disks (RAID) first because EMC, "the 
leading independent computer, storage manufac- 
turer," was exclusively devoted to 'computer 
storage and was an established technology pro- 
ducer .with "the technical' expertise, resources 
and commitment necessary' to marry these two 
technologies and to do so in less time than our 
competitors." (Id.) The price of EMC's common 
stock rose in response to this announcement. 
(#13, para. 26) 

EMC issued a press release on December 21, 
1990 reporting the "rapid acceptance" and suc- 
cess of a disk drive for IBM computers produced 
by EMC. (#13, para. 28) In addition, the Com- 
pany stated that several new products were 
planned for 1991 that were expected to main- 
tain or improve EMCs market position among 
third party suppliers of drives. (Id.) 

On January 28, 1991, EMC announced that it 
expected the financial figures for the fiscal year 
ending December 29, 1990, to reflect substantial 
improvements over the prior year. (#13, para. 
29) According to Ruettgers, the increases were 
purportedly "a result of many factors including 
improvements in product quality and produc- 
tion efficiencies and continued strong market 
demand for our products." (Id.) 

On February 12, 1991, EMC announced that 
orders of Symmetrix were backlogged well into 
the first quarter of 1991 and, consequent to the 
high demand and performance of the product 
since its introduction, that prices would be in- 
creased. (#13, para. 30) 

On February 19, 1991, record revenues for 
1990, up 29 percent over 1989, were announced 
by EMC. (#13, para. 31) The Company declared 
that it anticipated its product sales to continue 
to grow throughout 1991, and that several new 
products and services were expected to be intro- 
duced. (Id.) The 1990 annual company report 
released March 29. 1991, included a letter from 
Egan and Ruettgers which described their goal 
for EMC: "to become the storage supplier of 
choice for the vast majority of users who, today, 
buy these products only from the computer 
manufacturer." (#13, para. 32) 

It was reported by Business Wire in early 
April, 1991, that EMC was enlarging its IBM 
mid-range product line to include new disk and 
tape products together with remote mainte- 
nance service. (#13, para. 33) These innovative 
technologies and services were reported to out- 
perform competitors and be advantageous to 
mid-range users not only in terms of cost, but 
also in data storage and security, better service, 
less downtime and reduced overhead. (Id.) Two 

©1992, Commerce Clearing House. Inc. 



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days subsequent to this announcement, the 
price of EMC's stock rose to $12 per share. (Id.) 

As reported on April 18, 1991, EMC,s first 
quarter 1991 revenues increased 27 percent over 
the same period in 1990 while net income in- 
creased by 240 percent. (/13, para. 34) Defen- 
dant Egan was quoted as stating: 

We feel that we are sending a clear signal 
that EMC is on solid ground and that the 
company will' continue to expand its position 
in the market; as- the leading independent 
supplier of technologically, advanced storage 
products for IBM mainframe and mid-range 
computer users. 

(W) ,,.,. 

The tenor of the annual meeting held on May 8, 
1991 was similarly upbeat as EMC's dramatic 
return to profitability and financial stability 
was detailed, (f 13, para. 38) 

During this period, the price of EMC stock 
continued to rise,' ultimately reaching a high of 
$13 per share on May 9, 1991. (#13, para. 35, 

38) Over the -same period, from October 22, 
1990 through May 9, 1991, Egan and Marino 
are each alleged to have sold hundreds of 
thousands of shares of EMC stock that they 
owned. (#13, para. 36, 37) 

The positive reports from EMC continued in 
May, 1991, when a co-marketing agreement 
with Sun Data, Inc. was announced. (#13, para. 

39) It was projected that this deal would gener- 
ate an additional $8-$10 million in revenue for 
EMC. (Id.) On June 18, 1991, the Company 
announced the introduction of the Champion 
Tape Subsystem, the first 20 gigabyte. (#13, 
para. 40) Nine days later, Dow Jones reported 
that EMC had received an order from Control 
Data Corp. for twenty Symmetrix data storage 
systems. (#13, para. 41) 

On July 11, 1991, it was announced that 
EMC expected lower than anticipated income 
for the second quarter of 1991. (#13, para. 42) 
Competitive pricing pressures combined with 
increases in expense levels were cited as the 
cause for the forecasted decline. (Id.) At the 
time of the announcement, defendant Egan 
stated: 

Although profitability this past Quarter will 
be less than Plan, we remain optimistic be- 
cause demand for our non-OEM Mid-range 
and Mainframe storage products continues to 
show strong steady growth and as volumes 
increase, we should achieve better economies 
of scale. In addition, there will be strong at- 
tention paid to costs and expenses for the 
remaining half of 1991. 

Id. 

Federal Securities Law Reports 



In response to this news. Analysts cut their pro- 
jections for EMC stock from approximately 20 
cents per share to 10 cents per share. (Id.) By 
July 12; 1991, the market price for EMC stock 
fell from over $1 1.00 per share to less than $7.00 
per shared (Id.) 

THE LAW < 

By its terms, Federal, Rule of Civil Procedure 
9(b) mandates that "(i]n averments of fraud or 
mistake, the circumstances constituting fraud or 
mistake' shall be stated, with particularity: Mal- 
ice, ^tent/lmowTedge and ,^&''cw&tittu>"'of 
the mirid of a person may be averred generally." 
In this Circuit,; Rule 9(b) has been' strictly ap- 
plied to securities fraud claims. See, e.g... Royal 
Business Group, Inc. v. Realist, Inc., 933 F2d 
1056, 1065-1066 (1 Cir., 1991); Rbmsni v. 
Shearson Lehman HuUon, 929 F2d 875, 878 (1 
Gir., 1991); New England Data Services, Inc. v. 
Bechcr, 829 F2d 286, 288 (1 Cir., 1987); Dris- 
coll v. Landmark Bank For Savings, 758 F-Supp. 
48, 51 (D. Mass., 1991). While summarizing 
precedent on this issue, the First Circuit re- 
cently reiterated: 

It is well settled that Rule 9(b) requires the 
plaintiff in a securities fraud case to specify 
the time, place and content of an alleged false 
representation . . . The requirement that sup- 
porting facts be pleaded applies even when 
the fraud relates to matters peculiarly within 
the knowledge of the opposing party. 

Romani v. Shearson Lehman Hutton, supra, 929 
F.2d at 878. (citations omitted) 

A primary purpose behind demanding such 
detail in the securities fraud context is "to pre- 
clude the use of a groundless fraud claim as a 
pretext to discovering a wrong or as a 'strike 
suit.' " New England Data Services, Inc. v. 
Bechcr, supra, 829 F.2d at 289; Romani v. 
Shearson Lehman Hutton, supra, 929 F.2d at 
878; Konstantinakos v. Federal Deposit Insur- 
ance Corporation, 719 F.Supp. 35, 38 (D. Mass., 
1989) 

To meet the Rule 9(b) specificity require- 
ments in a case such as this where the allega- 
tions are made upon information and belief, it is 
imperative that both "the source of the informa- 
tion and the reasons for the belieF' be laid out in 
the amended complaint. Romani v. Shearson 
Lehman Hutton, supra, 929 F2d at 878 (citing 
cases) (emphasis supplied); Driscoll v. 
Landmark Bank For Savings, supra, 758 
F.Supp. at 51; Akerman v. Bankworcester Cor- 
poration, 751 F.Supp. 11. 12 (D. Mass., 1990). 
The First Circuit has "been especially rigorous 
in demanding such factual support in the securi- 
ties context." Romani v. Shearson Lehman Hut- 
ton, supra, 929 F2d at 878. In short, to pass 
muster, not only must the time, place and con- 

1196,636 



233 



92,996 



New Court d>ea*km* 
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1504 5-27-92 



tent specifics be alleged, the complaint must 
also contain • ' '&>' 

'■'■... factljal alligations that would support a 
reasonable inference that adverse circum- 
stances existed at the time (the statement or 
representation was made), and were known 
and deliberately or recklessly disregarded by 
defendants. 

Romani v. Shearson Lehman Mutton, supra, ^29 
f^d'at 87B\T.$ee~'*lso, Chanel yachbn\v, 
Jk>fcafl^:;inc,;XiVil' Action No. 90-10758tT, 
Memorandum jat p. 2 0. Mass., December" 30, 
1991); In jRe Eealthco International, Inc., Civil 
Action Not 9l-107ltfMA; Memorandum and. Or- 
der at p. 5 (D."Mass.,>Ioy, 7,' 1,991); priscbV v. 
tahdmark Bank' "For Savmgs, supra, '758 
F.Supp. at 52. .- 

The plaintiffs have quoted and paraphrased 
from. a. -compilation of SEC filings, newspaper 
articles,.5ihalyst» reports and press releases in 
drafting -IhCi eighteen paragraphs of the 
amended complaint incorporating the allegedly 
false and misleading statements. From all. ap- 
pearances, several of the affirmative announce- 
ments about which the plaintiffs complain are 
accurate historical facts, i.e, quarterly revenue 
reports. Statements, opinions and projections at- 
tributable to particular individual defendants, 
although uniformly positive and upbeat, are 
generalized. Reports from the media and stock 
analysts add to the patina of EMC's success. 
But such a catalogue, no matter how exhaustive, 
coupled with the bare allegation that the repre- 
sentations were false and misleading, quite sim- 
ply is not enough. See, e.g., Driscoll v. 
Landmark Bank For Savings, supra, 758 
F.Supp. at 52-53; Akerman v. Bankworcester 
Corporation, supra, 751 F.Supp. at 13. Loan v. 
Federal Deposit Insurance Corporation, supra, 
717 F.Supp. at 967. 

There is no question, nor do the defendants 
dispute, that the time, place and content pre- 
requisites of Rule 9(b) are met. In addition, the 
plaintiffs set forth six categories of "adverse 
information" the defendants are alleged to have 
concealed or failed to disclose but which infor- 
mation was necessary to make their statements 
not misleading. (#13, para. 43 a-f) However, in 
marked contrast to the prior detail, at this junc- 
ture of the pleading a broad brush approach is 
adopted. For example, it is alleged that 

EMC was actually experiencing a deteriora- 
tion in its markets as a result of weakening 
economic conditions which would adversely 
affect the Company's growth rate in sales and 
revenues and which would cause operating 
income to decline. 

Amended Complaint f\Z, para. 43(a). 

What is the source of this information? What is 
the reason for believing that it is true? What is 

1f 96,636 



the factual basis for stating that if true, the 
defendants both knew of this information and 
knew it to be true at the time they made the 
statements? There are simply no facts alleged to 
substantiate the conclusion either that EMC 
was experiencing a deterioration in its markets 
or the reasons for the belief, and that the de- 
fendants knew and deliberately disregarded that 
adverse circumstance at the time any contrary 
or misleading representations were made. , , 

:".• The'remaining categories^ adverse informa- 
tion identified, with one exception discussed be- 
low, 'are of the same ilk and suffer from the same 
deficiency. At no place in' the amended com- 
plaint do the plaintiffs allege concrete, quantifi- 
able information which the defendants knew but 
disregarded in making optimistic public state 
menu such as would render those statements 
either false or misleading.. There are no facts 
pleaded to support an inference that the defend- 
ants had no reasonable basis for making the 
predictions at the time they were made. In 
short, not only is the alleged adverse informa- 
tion, too conclusory and amorphous, it is by no 
means related, directly or by inference, to the 
state of the defendants' knowledge at the rele- 
vant time. 

In paragraph 43(e), plaintiffs do state specific 
facts which the defendants are alleged to have 
known. Plaintiffs allege that "[c]ontrary to hav- 
ing a competitive edge over IBM and other 
competitors, EMC was, as alleged in the com- 
plaint in International Business Machines Corp. 
and IBM Credit Corp. v. EMC Corp., filed in 
this Court (91-10336N), improperly removing 
and utilizing components from IBM equipment 
to manufacture and market its own products." 
However, there are three problems. First, there 
is no allegation as to the time period when EMC 
was allegedly doing this. Second, and more im- 
portant for present purposes, there is nothing to 
indicate what statement by EMC this "adverse 
information" proves false and misleading. There 
is in the first amended complaint an allegation 
dealing with IBM to the effect that EMC's 
Symmetrix product was more technologically 
advanced than IBM's product (/13, para. 25). 
However, there is no allegation that the IBM 
parts which EMC allegedly put into its products 
were put into the Symmetrix product, and de- 
fendants deny that the suit with IBM refer- 
enced in paragraph 4(e) has anything to do with 
EMC's Symmetrix products. 

In paragraph 28 of the first amended com- 
plaint, IBM is mentioned in the context of the 
statement by EMC that it had developed a disk 
drive which could be used in IBM computers; 
there is no allegation that there were any IBM 
components in EMC's disk drives. Similar refer- 
ences in statements by EMC set forth in para- 
graph 29 that EMC had "successfully beaten its 
competition (including IBM) to market with 

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RAID technology products by well over a year" 
and in the development Unisys technologies 
bear no apparent relation to the use of IBM 
products in EMC systems. Rather, defendants 
contend that the subject of the suit involves 
"components of IBM 3090 main frame com- 
puters." Lastly,' no relationship is shown be- 
tween the alleged use of IBM products as set 
forth in paragraph 43(e) and the April state- 
menu set forth in paragraphs 32 and 33 of the 
first amended complaint that EMC 

. . . anticipated sales of its products in both 
the IBM mid-range and mainframe markets 
to continue to grow throughout 1991 and that 
it planned to introduce several new products 
and services in both the IBM as well as 
Unisys markets. 

First Amended Complaint, /13, para. 32. 

Plaintiffs must set forth facts that "indicate 
[the] falsity of the facts that defendantfs] did 
disclose." Capri Optics Profit Sharing v. Digital 

Equipment Corp., F2d (1 Cir., No. 

91-1385, 11/18/91). Put another way, plaintiffs 
must show a link between what was disclosed 
and what was not disclosed; they have failed to 
do so. 

Third, to the extent that material from the 
other complaint is incorporated by reference, 
the pleading is improper. The papers in the 
other suit were filed before the instant case, and, 
so far as appears, are public documents which 
plaintiffs can readily examine. There is no ex- 
cuse for selling forth conclusory factual matter 
from an unrelated suit ("EMC was . . . improp- 
erly removing and utilizing components from 
IBM equipment to manufacture and market its 
own products.") without (a) relating the factual 
matter to a particular statement by the defend- 
ants, (b) demonstrating how the factual matter 
renders the particular statement false or mis- 
leading and (c) alleging facts which would 
demonstrate that the defendants were in posses- 
sion of this factual matter at the time they 
made the statement. 

In conclusion, the federal claim contained in 
the first amended complaint should be dismissed 
for failure to comply with Rule 9(b), 
Fed.R.Civ.P. If the state claims are brought 
pursuant to the pendent jurisdiction of the 
Court, the Court should decline to hear them 
and they should be dismissed. If they are 
brought pursuant to the supplemental jurisdic- 
tion of ihe Court as set forth in 28 U.S.C. 
§ 1367, they should be dismissed pursuant to 28 
U.S.C. § 1367(cX3). 

THE QUESTION OF GRANTING LEA VE TO 
AMEND FURTHER 

The question arises as to whether leave to 
amend should be granted; I am of the opinion 
thai it should not. The plaintiffs' original corn- 
Federal Securities Law Reports 



plaint was challenged on August 14, 1991 with a 
motion to dismiss and a lengthy memorandum 
pointing out with specificity the failure to com- 
ply with Rule 9(b), Fed.RCiv.P., and citing 
with particular emphasis the decision in the 
Romani case. See ff6 and 7. It is a compelling 
inference that in drafting their First Amended 
Complaint (/13) which was filed on September 
17, 1991, the plaintiffs took their best shot at 
drafting a plaeding which complied with the 
rule. There is no indication that they nave any 
further factual matter which they -could plead 
that would satisfy the requirements of th» rule. 

Respecting the case of International Business 
Machines Corp. and IBM Credit Corp. v. EMC 
Corp., referenced in paragraph 43(e) of the first 
amended complaint, if there was any factual 
information revealed by that case which sup- 
ported the contention that any of EMC's state- 
ments of which the plaintiffs complain were 
false and misleading, it is a sure bet that such 
factual information would have been set out in 
the first amended complaint in florid detail. 
Granting leave to amend would be futile. 

The bottom line is that not only was plain- 
tiffs' first amended complaint "dead on arri- 
val," there is no reasonable basis for inferring 
that any future complaints would "arrive" in 
any more viable condition. Backman v. Polaroid 
Corporation, 910 F.2d 10, 13 (1 Cir., 1990). 

In addition 10 the non-complinace with Rule 
9(b), defendants assert that the first amended 
complaint should be dismissed because it alleges 
no facts upon which it could be found that EMC 
had a duty to disclose, a requirement set forth in 
the Backman case. I have not dealt with this 
issue because I am of the opinion that it is, in 
essence, a variant of the Rule 9(b) problem. In 
the Backman case, the Court reiterated its hold- 
ing in Roeder v. Alpha Industries, Inc., 814 F.2d 
22, 26-27 (1 Cir., 1987) to the effect that a duty 
to disclose only arises in the situation in which 
(a) a corporate insider trades on confidential 
information, (b) a statute or regulation requires 
disclosure, and (3) a corporation has made an 
inaccurate, incomplete or misleading prior state- 
ment. As the Backman case points out, however, 
this requirement 

. . . does not mean that by revealing one fact 
about a product, one must reveal all others 
that, too, would be interesting, market-wise, 
but means only such others, if any, that are 
needed so that what was revealed would not 
be "so incomplete as to mislead." 

Backman v. Polaroid Corp , supra, 910 F.2d at 
16 quoting from SEC v Texas Gulf Sulphur Co., 
401 F.2d 833. 862 (2d Cir. 1968), cert, denied. 
394 U.S. 976. 89 S.Ct. 1454, 22 L.Ed.2d 756 
(1969) 

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235 



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In the case at hand, the facts which would 
form the- basis of. the assertion that any of 
EMC's statements were "inaccurate, incomplete 
or misleading" triggering a duty to disclose 
would be the very facts which are required to be 
pleaded in order to comply with Rule 9(b), 
FediLCiv.P. . Similarly, any "confidential in- 
sider information" would most likely be the 
same .type of information, i.e., facts known at 
the time which were not disclosed * but should 
have been so as to prevent the statements which 
were released from being "so incomplete as to 
mislead." See generally Capri Optics Profit 
Sharing v. Digital Equipment Corp., supra. 

■■ In sum, adherence to the requirements of 
Rule 9(b), Fed.R.Civ.P., as interpreted by this 
Circuit, will, in most cases, provide the basis for 
judging whether a complaint passes muster 
under Backman or is, on the other hand, "dead 
on arrival." 

..." .RECOMMENDATIONS 

I RECOMMEND that Count I of the first 
amended complaint, the federal securities claim, 
be DISMISSED for failure to comply with the 
requirements of the Rule 9(b), Fed.R.Civ.P. The 
two remaining claims in the first amended com- 
plaint, i.e., Counts II and HI, arise under state 
common law. If the claims are brought pursuant 
to the Court's pendent jurisdiction, United Mine 
Workers v. Gibbs, 383 U.S. 715, 726 (1966), I 
RECOMMEND that the Court decline to hear 
them and that they be DISMISSED. If they are 
brought pursuant to the supplemental jurisdic- 
tion of the Court as set forth in 28 U.S.C 
§1367, I RECOMMEND that they be DIS- 
MISSED pursuant to 28 U.S.C. § 1367(cX3). I 
FURTHER RECOMMEND that judgment be 
entered FORTHWITH dismissing the amended 
complaint and that the plaintiffs not be granted 
leave to file a second amended complaint. 

REVIEW BY THE DISTRICT COURT 

The parties are hereby advised that under the 
provisions of Rule 3(b) of the Rules for United 
States Magistrates in the United States District 
Court for the District of Massachusetts, any 
party who objects to this report and these rec- 
ommendations must file a written objection 
thereto with the Clerk of this Clerk within 10 
days of the party's receipt of this Report and 
Recommendation. The written objections must 
specifically identify the portion of the recom- 
mendations, or report to which objection is made 
and the basis for such objections. The parties are 
further advised that the United States Court of 
Appeals for this Circuit has indicated that fail- 
ure to comply with this rule shall preclude fur- 
ther appellate review. See Park Motor Mart, 
Inc. v. Ford Motor Co., 616 F2d 603 (1 Cir., 
1980); United States v. Ve^a, 678 F2d 376, 
378-379 (1 Cir., 1982); Scott v. Schweiker, 702 
F2d 13, 14 (1 Cir.. 1983). See also Thomas v. 
Am, 474 U.S. 140(1985). 

1196,636 



REPORT AND RECOMMENDATION ON 

ROGER M. MARINO'S MOTION. TO STRUCE 

AND FOR COSTS AND EXPENSES, 

INCLUDING ATTORNEYS: FEES (/20) 

Defendant Marino filed, a- "motion to strike 
and request for costs and attorneys' fees in re- 
sponse to the original complaint. .See f8. Plain- 
tiffs filed a brief opposition stating that the 
motion was moot because of the filing.of the first 
amended complaint. (#11)1 The instant motion 
(f20) to strike and for costs and expenses, in- 
cluding attorneys' fees, was filed on October 1, 
1991 in response to the allegations of the first 
amended complaint. No opposition or response 
has been filed by the plaintiffs. 

Accordingly. I RECOMMEND that if the 
Court adopts the Report and Recommendation 
to the effect that this case be dismissed for 
failure to comply with Rule 9(b), Fed.R.Civ.P., 
that the motion (/20), to the extent that it seeks 
to strike matter from the first amended com- 
plaint, be DEND2D as moot and that the mo- 
tion (/20), to the extent that it seeks an award 
of costs and expenses, including attorney's fees, 
for violations of Rule 11, Fed.R-Civ.P., be AL- 
LOWED. The defendant Marino is granted 
leave to file and serve affidavit(s) detailing the 
costs and expenses, including attorney's fees, 
claimed; the plaintiffs may file an opposi- 
tion/response to the amount of the claim within 
fourteen (14) days (including Saturdays, Sun- 
days and holidays) after the filing of defendant 
Marino's affidavit or affidavits. 

The parties are hereby advised that under the 
provisions of Rule 3(b) of the Rules for United 
Stales Magistrates in the United States District 
Court for the District of Massachusetts, any 
party who objects to this report and recommen- 
dation must file a written objection thereto with 
the Clerk of this Clerk within 10 days of the 
party's receipt of this Report and Recommenda- 
tion. The written objections must specifically 
identify the portion of the recommendation, or 
report to which objection is made and the basis 
for such objections. The parties are further ad- 
vised that the United States Court of Appeals 
for this Circuit has indicated that failure to 
comply with this rule shall preclude further ap- 
pellate review. See Park Motor Mart, Inc. v. 
Ford Motor Co., 616 F2d 603 (1 Cir., 1980); 
United States v. Vega, 678 FJ2d 376, 378-379 (1 
Cir., 1982); Scott v. Schweiker, 702 F2d 13. 14 
(1 Cir., 1983). See also Thomas v. Am, 474 U.S. 
140(1985). 

Opinion of SKINNER, District Judge. 

This case arises in the wake of a general 
downward trend in the value of computer indus- 
try stock. Plaintiffs, as members of a class of 
purchasers of shares of EMC Corporation stock, 
allege that the company, through its officers, 

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92,999 



made, a number of false and misleading state- 
ments and omissions in violation of § § 10(b) and 
20(a) of the Securities Exchange Act of 1934 
and Rule 10b-5,. promulgated thereunder. The 
defendants responded to the initial complaint by 
moving to dismiss, based in part on plaintiffs' 
failure to allege fraud with particularity in ac- 
cordance with Fed.R.Civ.P. 9(b). In addition, 
defendant Roger M. Marjno, a former officer 
and director 'of EMC, filed aseparate motion to 
strike references to him from (he complaint as 
immaterial and for sanctions under 
Fed:R.Civ.P. 11. Marino asserts that plaintiffs 
conducted no reasonable inquiry before filing 
suit, and that '-'ho 'reasonable basis exists for 
naming him as a party defendant. In lieu of 
opposing the defendants' motions, the plaintiffs 
filed an amended complaint. All defendants re- 
sponded by moving to dismiss the amended com- 
plaint, again charging plaintiffs with failure to 
comply with Rule 9(b). Marino, again named as 
a defendant, renewed his prior motion to strike 
and for sanctions. 

The motions were referred to Magistrate 
Judge Collings, who issued a report and recom- 
mendation on each motion. The recommenda- 
tions were to allow the defendants' motions to 
dismiss and to impose Rule 1 1 sanctions for the 
plaintiffs' role in improperly naming Marino as 
a defendant. Plaintiffs now object to the reports 
and recommendations of the magistrate judge. 

Background 

I determine the merits of this dispositive mo- 
tion de novo on review of the contested report 
and recommendation of the magistrate. 
Fed.R.Civ.P. 72(b). For purposes of a motion to 
dismiss, I take the material allegations of the 
complaint as true. Lessler v. Little, 857 F.2d 
866, 867 (1st. Cir. 1988), cert denied, 489 U.S. 
1016 (1989). Defendant EMC Corporation is a 
Massachusetts computer-related company 
whose stock is traded on the New York Ex- 
change. The company had been a self-pro- 
claimed sucess story in the industry and had 
issued several optimistic statements concerning 
its prospects for future sales. From the fall of 
1990 until the late spring of 1991, the stock rose 
in value from about $7 per share to its all-time 
high of $13 per share. Then, on thursday and 
firday, July 11 and 12, 1991, following the com- 
pany's thursday morning announcement that 
second quarter 1991 income would be lower than 
previously expected, the price of the stock 
sharply fell from $11 to less than $7. The follow- 
ing monday, plaintiffs filed this suit. 

^ The complaint alleges that the reports of 
EMC's financial condition and future sales pros- 
pects were overly optimistic and that the de- 
fendants knew of the false nature of the 
statments and omissions at the time they caused 
the statements and omissions to be made in 

Federal Securities Law Reports 



order to artificially inflate the price of the stock 
and defraud the plaintiffs, who purchase EMC 
stock while it was rising: in value. With one 
exception, the allegations are cast in sweeping 
generalizations, such as "EMC was actually ex- 
periencing a deterioration in its markets." The 
exception is the plaintiffs allegation that during 
the six-month period of rising stock price, de- 
fendants Egan and Marino were selling large 
blocks of stock which they'' had s personally 
-owned. 

Discussion 

Rule 9(b) requires a plaintiff to specify the 
time, place, and content of an alleged false rep- 
resentation in his complaint. Wayne Invest., 
Inc. v. Gulf Oil Corp., 739 F2d 11, 13 (1st Cir. 
1984). The complaint must also contain some 
factual support for the allegations of fraud. New 
England Data Services, Inc., v. Becher, 829 
Y2d 236, 288 (1st Cir. 1987). In Romani v. 
Shearson Lehman Hutton, 929 F.2d 875 (1st 
Cir. 1991), the first circuit affirmed a trial 
court's dismissal of a complaint for failure to 
plead securities fraud with particularity because 
the complaint contained "no factual allegations 
that would support a reasonable inference that 
adverse circumstances existed at the time of the 
(alleged misrepresentation] and were known 
and deliberately or recklessly disregarded by 
defendants." Id. at 878. The Romani court de- 
scribed the first circuit's adherence to the Rule 
9(b) particularity requirement as "especially 
rigorous" when applied in the securities c ntext 
as a guard against strike suits. Id. 

The complaint adequately identifies the time, 
place, and content of the alleged false represen- 
tations and omissions of the defendants. How- 
ever, there is a void where there should be 
allegations of specific facts tending to show that 
the defendants knew that the optimistic projec- 
tions were false when made. Like those in the 
Romani complaint, the generalizations alleged 
in the instant complaint are not sufficiently 
particular to satisfy Rule 9(b). Rather, they are 
conclusions apparently based on only one set of 
facts, i.e., the personal stock sales. The defend- 
ants' sale of stock is the most damaging of 
plaintiffs' allegations, and might, in combina- 
tion with other circumstances, support an infer- 
ence of fraud. In this case the sales began well 
before the deterioration of EMC's prospects. 
Standing alone, the fact that the sales occurred 
does not support an inference of fraud. See 
Pinkowitz v. Data General Corp., No. 
90-11854-Z. 1991 U.S. Dist. LEXIS 19228 (D. 
Mass. Dec. 27, 1991). 

Rule 11 Sanctions 

The magistrate judge correctly noted thai the 
plaintiffs did not respond to Marino's motion for 
sanctions by way of formal written opposition. 
The plaintiffs did argue against Marino's dis- 

1 96,636 



237 



93,000 



New Court Decision* 
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1504 5-27-92 



missal in a footnote to its opposition to the 
defendant's motion to dismiss, and the plaintiffs 
also orally argued against some portions of Ma- 
rino's motion to the magistrate judge. I will 
treat the motion as if it were properly opposed. 

The plaintiffs' basis for joining Marino is ap- 
parently that his ownership of over 10% of out- 
standing EMC stock gives rise to his status as a 
"controlling person" under Section 20(a) of the 
Securities Exchange Act of 1934, 15 U.S.C. 
§ 78t(a), which provides: 

Every person who, directly or indirectly, con- 
trols any person liable under any provision of 
this chapter . . . shall also be liable jointly and 
severally . . . unless the controlling person ac- 
ted in good faith .. . 

Id. Marino's contention that he no longer was an 
officer or a director of the corporation at the 
time he sold his stock is not relevant to the issue 
of whether he was a controlling person under the 
Act. Marino has not made a showing that the 
plaintiffs' "controlling person" theory of recov- 
ery is so flawed as to trigger the imposition of 
sanctions, and in the absence of such a showing I 
will decline to do so. 

Supplemental Claims 

Under the supplemental jurisdiction statute, 
which codified the doctrines of pendent and an- 
cillary jurisdiction, a district court may decline 



to hear state law claims once the federal claims 
have been dismissed. 28 U.S.C. § 1367(cX3). See 
also United Mine Workers v. Gibbs, 383 U.S. 
715 (1966). The federal claims having been dis- 
missed in this case, the state law claims will be 
dismissed as well. 

Leave to Amend 

Plaintiffs request leave to amend their com- 
plaint, should the complaint fail to comply with 
the requirements of Rule 9(b). Plaintiffs have 
had ample opportunity to allege any facts of 
which they are aware from which liability may 
flow. Indeed, their First Amended Complaint 
itself was a response to an earlier charge that 
the original complaint failed to comply with 
Rule 9(b). The complaint fails because the 
plaintiffs apparently wish to embark on a fish- 
ing expedition at the defendants' expense, not 
because the plaintiffs have been imprecise in 
their choice of words. The complaint will be 
dismissed with prejudice. See Romani, 929 F.2d 
at 880-81. 

Accordingly, the plaintiffs' objection to the 
magistrate judge's report and recommendation 
to dismiss is overruled and the plaintiffs' objec- 
tion to the magistrate judge's report and recom- 
mendation to impose sanctions is sustained. The 
complaint is dismissed with prejudice. No Rule 
1 1 sanctions will be imposed. 



[H 96,637] Granada Investments, Inc. v. DWG Corporation, et al. 

United States Court of Appeals, Sixth Circuit. Nos. 91-3297/3343/3399/3402/3407. April 30, 
1992. Opinion in full text. 

On appeal from the United States District Court for the Northern District of Ohio. 
District court opinion is at CCH 1989-1990 Decisions Tr. Binder f 94,774. 

1. Shareholders — Derivative Actions — Settlement. — A settlement between a substantial 
shareholder asserting derivative claims and the company and its directors was fair since sharehold- 
ers derived a benefit from the settlement in that it released the company from all liability for 
present and future claims and provided for changes in corporate governance that would result in 
potential corporate savings of $108 million. The breadth of the releases did not in itself vitiate the 
fairness of the settlement, particularly since objectors did not specify any future claim which might 
be barred or name any future litigant. 

See H 24.281A.3041, "Exchange Act— Proxies" division. Volume 3. 

2. Shareholders — Derivative Actions — Settlement. — A settlement term providing for "costs 
not limited to the legal services" supplied by attorneys for a substantial shareholder asserting 
derivative claims properly reimbursed the shareholder for all costs related to advancing the 
litigation, such as fees for accountants and investment bankers, since these expenses were related to 
claims pursued on behalf of all shareholders. 

See H 24.281A.4845, "Exchange Act — Proxies" division, Volume 3. 

3. Shareholders — Derivative Actions — Settlement. — Objectors to settlement of a substan- 
tial stockholder's derivative action who did not challenge the reasonableness of the final bill for legal 
services could not base an objection on the absence of evidence relating to rates per hour. No 
particular form of proof for considering the reasonableness of legal fees is required. All that is 
necessary is evidence supporting the hours worked and rates claimed. 

See 11 24.281A.4845. "Exchange Act — Proxies" division. Volume 3. 



H 96,637 



©1992. Commerce Clearing House. Inc. 



238 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOMENICI 

FROM RICHARD J. EGAN 

Q.l. During his testimony, Mr. Lerach made a number of state- 
ments regarding the lawsuit against your company. Please respond 
to those statements. 

A.1. Thank you for allowing me to respond to Mr. Lerach's anec- 
dotal attempt to disparage me and the other witnesses from the 
business community that testified before your Senate Subcommit- 
tee. 

Mr. Lerach begins his attack in the same manner as most strike 
suit lawyers initiate their case that is without any basis of fact, an 
absence of legal allegations and innuendo about inside stock sales. 
Most of us that are Key employees and/or company founders usu- 
ally own significant shares in the enterprise and sell some during 
the period usually restricted to after the quarter's financial results 
have been issuea, but before the last month of the quarter. There 
is nothing wrong with this and Mr. Lerach knows it, but he tries 
to convince the Committee as he tries to convince a Judge/Mag- 
istrate that this is a sinister act with fall knowledge of how the 
quarter's results will turn out. Everyone knows that most manufac- 
turing companies particularly capital goods and hi-tech orders and 
shipments occur in the latter month (and often weeks) of the quar- 
ter. No one knows how bad (or well) these results will be. 

Mr. Lerach, in his testimony, also stated that the EMC Strike 
Suit, with which he was familiar, was determined by the judge to 
"not be frivolous." This statement is not totally correct. What the 
Court actually said was that it "would not allow the Plaintiffs and 
their lawyers to go on a fishing expedition at the Defendant's ex- 
pense to justify the basis of their complaint." The judge further 
commented on the frivolous aspect by clearly stating in his opinion 
"this case was dead on arrival." A transcript of the judge's opinion 
was submitted with my testimony on the 17th. 

Q.2. Some witnesses asserted that the current versions of Rule 11 
and Rule 9(b) of the Federal Rules of Civil Procedure provide suffi- 
cient protection against merit-less suits. Would you or your compa- 
ny's general counsel please comment on that assertion. 
A.2. It has been said that "any damn fool that can find the court- 
house can file a lawsuit" and when that happens the process begins 
which is almost always more costly in time and money (and lost 
opportunities) than the outcome. The reason being that most 
Judge/Magistrates are unwilling to discuss a case or issue sum- 
mary judgments without some discovery. I am not sure why they 
do this because it is very rare that the initial strike suit filing con- 
tains any facts or specific allegations (other than some inside per- 
sons may have sold some of their stock). 

Please bear in mind that we are dealing with some very sophisti- 
cated and experienced Strike Suit law firms (about a dozen) and 
they are usually much more versed in these cases that the Judge/ 
Magistrates. To my knowledge there are no law firms which spe- 
cialize in tho defense of securities related class-action suits. 

Q.3. Changes to Rule 11 have been proposed to make the award 
of sanctions permissive, rather than mandatory; to make the sanc- 
tions payable to the court rather than the injured party; to make 



239 

the rule inapplicable to the discovery process and to create a safe 
harbor that would bar the award of sanctions if the challenged 
pleading was withdrawn by the alleged offender within 21 days of 
service of a motion for sanctions, among other changes. 

Would the proposed changes in Rule 11 provide greater or lesser 
protection against merit-less suits? 

A.3. The proposed changes should provide a fairer contest and we 
would favor them. 

Please note that to my knowledge sanctions are rarely invoked 
so I would say the mandatory aspect is not being applied. 

Q.4. In view of the proposed changes to Rule 11 what 10(b)(5) spe- 
cific statutory changes should be made to strengthen Rule 11. 

A.4. Please accept the following list of recommended changes which 
I hope answers Q.4. and may well go somewhat beyond. 

I. To provide some reasonableness of the claim 

a. There should be a standard of "clear and convincing" proof or 
allegations of fraud against companies. This would discourage law- 
suits based upon statements of a company that turned out to be in- 
accurate, but that were not intended to mislead investors or the 
public. 

b. Establish the SEC's role to review all 10(b)(5) complaints be- 
fore they are actually filed. I believe this could be made self-funded 
from fees paid by the participants. 

c. Implement a perpetual "statutory offer of judgment." Once a 
class-action suit has begun, it goes on endlessly. By allowing either 
party the opportunity to settle the matter at any time under the 
terms of Rule 68 should promote reasonableness. 

d. Require that all 10(b)(5) cases be submitted to Alternative Dis- 
pute Resolution (ADR). 

e. Perhaps some combination of (c) and (d). 

II. Discourage Professional Plaintiffs 

a. Plaintiffs should not be "invisible." They should be made to ap- 
pear immediately and should not be allowed to become "profes- 
sional," that is appear as Plaintiffs in lawsuit after lawsuit. 

b. Contracts, arrangements, and relationships with plaintiffs and 
their respective law firms should be made discoverable. 

Q.5. How long did it take to get your case dismissed? How much 
of your own time was expended in activities related to getting the 
case dismissed? 

A.5. Our second Strike Suit (we paid off the lawyers in the first 
one) took eight months. Our CFO and I each spent approximately 
10 hours each week for about six months. Initially it was more and 
in the final stages more as well. I would estimate total time aver- 
aged about 15 percent of our available time. 

Q.6. How much did it cost you in legal fees? 
A.6. Approximately $200,000 (outside fees only). 

Q.7. One of the witnesses later in the day will testify that Harvey 
Pitt, a leading lawyer for the defendants in securities cases, has 
written that "Federal courts have displayed a striking willingness 
to dismiss these suits." 



240 

Harvey Pitt testified before this subcommittee at an earlier hear- 
ing that he routinely counsels his clients to settle these types of 
cases regardless of the merits because it is the only option that 
makes economic sense. 

I don't want you to necessarily respond to your own experiences, 
but you know many other CEOs with cases similar to yours. Have 
you ever heard anyone complain that their lawyers tell them that 
the only option that makes economic sense is to settle and to get 
on with life and business? 

A.7. Yes. This is usually the recommendation. The exception usu- 
ally occurs when the UEO is either fed up with these frivolous 
cases and/or decides to show the strike suit firm that they refuse 
to settle. 

Mr. Pitt's advice is certainly popular because (and despite Rule 
11) these cases often take on a life of their own and they are im- 
mensely distracting and time consuming. The Judge/Magistrate 
usually allows the Plaintiffs lawyers to depose every officer and 
key employee and request every document in their search for even 
the slimmest comment which could be construed to induce their 
Plaintiff— by the way the "Plaintiffs" are usually in cahoots with 
the Strike Suit firms and rarely appear. 

Usually the advice to settle does not occur as a strong rec- 
ommendation until both sides have engaged in extensive "legal 
work." 

Q.8. Each of you had lawsuits triggered by a drop in your stock's 
price. What has happened to your stock in the period since the law- 
suits were filed and the time the cases were settled or dismissed? 

A.8. Case #1 (we settled). The stock price remained at about the 
price it was when the case was filed. Case #2 (we won/case was dis- 
missed with prejudice). The stock rose over the eight month period 
following the strike suit filing. 

Thank you and your fine staff for the time and attention this 
most insidious matter is receiving. It would be a welcome relief if 
legislation could be enacted that would level the playing field be- 
tween businesses and the parasitic strike suit lawyers that exact 
this additional tax on companies. A burden that none of our foreign 
competitors must bear. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOMENICI 

FROM THOMAS DUNLAP, JR. 

Thank you for the opportunity to appear before the Securities 
Subcommittee on June 17 to present Intel's views on private litiga- 
tion under the Federal Securities laws. 

Q.l. During his testimony, Mr. Lerach made a number of state- 
ments regarding the lawsuit against your company. Please respond 
to those statements. 

Aul. Mr. Lerach asserts that a District Court Judge found that 
"Intel had obtained a verdict through fraud and misrepresentations 
by concealing from the court material evidence in support of AMD's 
position." This is not true, and a simple reading of the Judge's 
opinion (i.e. a minimum diligent review of the facts) would have re- 
vealed this to Mr. Lerach before he filed the lawsuit against Intel 
and before he testified before the subcommittee. 



241 

The truth is that a new trial was granted by the District Court 
Judge because he found that Intel had not delivered certain docu- 
ments to AMD (including one which was in AMD's files) during the 
pretrial proceedings. The Judge did not find that Intel had commit- 
ted any fraud or intentional misrepresentation. He found that a re- 
trial could be granted on the basis of an "avoidable accidental omis- 
sion." 

Q.2. Some witnesses stated that the current versions of Rule 11 
and Rule 9(b) of the Federal Rules of Civil Procedure provide suffi- 
cient protection against merit-less suits. Would you or your compa- 
ny's general counsel please comment on that assertion? 

Changes to Rule 11 have been promised to make the award of 
sanctions permissive, rather than mandatory; to make the sanc- 
tions payable to the court rather than the injured party; to make 
the rule inapplicable to the discovery process and to create a safe 
harbor that would bar the award of sanctions if the challenged 
pleading was withdrawn within 21 days of service of a motion for 
sanctions, among other changes. 

A.2. We strongly disagree that Rule 11 sanctions provide sufficient 
protection against merit-less suits. In our case, we were forced to 
spend approximately $600,000 for outside attorney fees, and hun- 
dreds of hours of critical management time. In Japan, these hun- 
dreds of hours are spent making products more competitive. Here 
they are wasted. 

Trie suggested changes to Rule 11 are of minimal consequence, 
and the changes enumerated in the question generally will reduce 
the effectiveness it already has. Rule 11 is rarely enforced in the 
Federal Courts, and the award of sanctions is, for all practical pur- 
poses, already permissive since Judges have great discretion in the 
range of sanctions. The safe harbor procedure is merely a sub- 
stitute for intelligent due diligence by the plaintiffs attorneys. We 
think that the plaintiff should be forced to undertake diligent ef- 
forts to determine if a violation has in fact occurred before the fil- 
ing of the case in the first place. 

If the safe harbor were used in conjunction with mandatory sanc- 
tions where a merit-less pleading was challenged but not with- 
drawn by the plaintiff, the process could turn out to have signifi- 
cant value. 

Q.3. Would the proposed changes in Rule 11 provide greater or 
lesser protection against merit-less suits? 

A.3. As indicated in my answer to Q.2. above the enumerated 
changes would provide slightly lesser protection. 

Q.4. Each of you had lawsuits triggered by a stock drop in your 
stock's price. What has happened to your stock in the period since 
the lawsuits ware filed and the time the cases were settled or dis- 
missed? 

A.4. In his testimony, Mr. Lerach made much of the fact that 
Intel's stock price dropped significantly following the announce- 
ment of the District Court's decision. What he did not mention is 
the fact that Intel's stock price recovered dramatically after the 
market had an opportunity to digest the news. In fact, at the time 
of the hearings, Intel was trading at around the level it reached 



242 

prior to the announcement of the Court ordered retrial. In trading 
since the hearings, general market conditions have pushed the 
price slightly lower than its pre-case high. 

Thank you for your courtesy in allowing us to give you and the 
Committee our views on this matter of importance to so many of 
us high growth companies. Please do not hesitate to contact me if 
there is anything further I can do to assist in this matter. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SASSER 

FROM MARK J. GRIFFIN 

Q.l. You point out in your testimony that private securities fraud 
litigation is an important component of enforcement against fraud. 
Indeed, private securities fraud lawsuits provide a means for inves- 
tors to obtain recovery for damages caused by fraudulent activity. 
They also serve as an adjunct to enforcement efforts to prosecute 
those who violate the securities laws and to deter future violations. 

If the system were to be reformed in an effort to deal with the 
so-called "litigation explosion," do you think more fraud would 
occur? 

In order to prevent a "fraud explosion," would regulation need to 
be stepped up? Would the regulators have sufficient resources to 
deal with this, particularly in light of severe fiscal restraints? 
A.1. First, NASAA respectfully disagrees with those who claim that 
there has been an "explosion in private securities fraud lawsuits. 
We are not aware of any empirical evidence which would prove this 
claim. In fact, the written statement of William R. McLucas, sub- 
mitted in conjunction with the June 17th hearing casts doubt upon 
this hasty assumption: 

According to statistics obtained from the Administrative Office 
of the U.S. Courts, the approximate aggregate number of securi- 
ties cases (including Commission cases) filed in Federal district 
court does not appear to have increased over the past two decades. 
Similarly, while the approximate number of securities class ac- 
tions filed during the past three years is significantly higher than 
during the 1980's, the numbers do not reveal the type of increase 
that ordinarily would be characterized as an "explosion." 1 

Therefore, before we examine remedies, NASAA respectfully sug- 
gests that Congress first determine that a "litigation explosion" has 
occurred, and second, if there indeed has been an "explosion," 
whether the present litigation, on balance, is harmful to the inter- 
ests of the U.S. economy and capital markets. It is reasonable, 
afterall, to assume that any rise in the number of cases directly 
correlates to a rise in the number of securities frauds. 

With that single recommendation behind us, I come to the first 
part of the question: If reforms were implemented, do we think 
more fraud would occur? The answer is a resounding "yes." 

NASAA has maintained from the outset that this package of 
anti-investor reforms not only would weaken, but indeed would 
devastate, the twin purposes for private rights of action under 
10(b)(5): recovery for past harm and deterrence of future harm. If, 
despite the present scheme of litigation, we still have witnessed the 



1 Written statement of William R. McLucas, Director, Division of Enforcement, Securities and 
Exchange Commission, before the Senate Securities Subcommittee, June 17, 1993, p. 9. 



243 

impressive financial frauds of the 1980's, what should we expect of 
a "reformed" system where co-conspirators are not held to account 
for the entire harm of the conspiracy, where RICO remedies are 
not available, or where even to get to court plaintiffs are exposed 
to "loser pays" liabilities that cannot be sustained by the average 
investor? 

It is impossible to measure the deterrent effect of the current 
system of private rights of action. For example, how do we estimate 
the number of frauds derailed by certified public accountants or 
lawyers unwilling to run the risk of collateral participation in a 
fraud because they will be held accountable as principals under 
joint and several liability? Similarly, who can estimate the quantity 
of fraud derailed by the prospect of damages trebled by operation 
of RICO? These cases, though not susceptible to quantification, are 
undoubtedly significant, and that significance will become quantifi- 
able if this package of reforms is passed. 

In answering the second part of the question, whether "stepped- 
up" regulatory efforts could prevent a "fraud explosion," NASAA 
would first have to know what such a stepping-up would entail. 
But supposing, for the moment, that we were being asked to specu- 
late on the form of stepped-up regulation, it is NASAA's belief that 
the extent of the "stepping-up" called for might well be 
unpalatable. 

For example, NASAA might be inclined to suggest that in order 
to adequately regulate in this area in the absence of private rights 
of action, the following enhancements to the current scheme of reg- 
ulation would be required: regular and frequent SEC oversight au- 
dits of private companies; granting the Securities and Exchange 
Commission and the states parens patriae powers to sue under 
10(b)(5) on behalf of investors for actual and punitive damages; 2 
decentralization of SEC powers to facilitate a more rapid response; 
or a statutory codification of Rule 10(b)(5) to alleviate the require- 
ment to prove scienter in 10(b)(5) claims. These would be the begin- 
nings of the list of revisions that might be suggested. 

If, on the other hand, "stepping-up" is intended to mean merely 
more regulatory funding, that will not balance the effects of these 
proposed anti-investor reforms. It is impossible to conceive of the 
existing Federal regulatory net being strengthened sufficiently by 
funding that it will screen out all or most securities fraud schemes 
before they inflict serious harm. For two related reasons, that 
thinking is flawed. 

First, I do not believe that it is economically feasible or practical 
to provide the level of funding required to achieve that goal, so in 
all likelihood, the net would not be impermeable and there still 
would exist the need for private remedies. Second, while the vision 
of optimum funding has a certain allure, fraud, by its very nature, 
is self-concealing and given time will find its own ingenious way to 



2 However, granting the regulators parens patriae powers will, unavoidably, fall short of bal- 
ancing the negative effects of these reforms. Even those who are advocates of strong govern- 
mental regulation acknowledge that the interests of the regulators in halting current and future 
wrongdoing often conflict with the interests of those who have already fallen victim. Presenting 
regulators with the principal responsibility to advocate the interests of past victims will only 
toss us more resolutely on the horns of this present dilemma. I am not saying that regulators 
cannot advocate victims' rights in come cases, but I am saying that it cannot be done in all 
cases. And in the end, it will probably be done less than adequately in any case. 



244 

succeed. In other words, a fraud scheme often succeeds not for the 
lack of good regulations or regulators, but in spite of them. 

Therefore, it makes no practical sense to think that stepped-up 
funding alone will be a satisfactory substitute for private rights of 
action. Moreover, if we truly expect a flood of fraud owing to litiga- 
tion reform of the sort that has been suggested, and I believe we 
should expect precisely that result, then it seems to me that our 
obligation is to avoid in the first place. It is much easier to simply 
maintain the levies provided by private rights of action. 

In answering this question, I would like to make it clear that 
while NASAA generally supports the current system of private 
rights of action in 10(b)(5) cases, it does not endorse litigation in 
any form. Nor does it wish to support a system that provides less 
accommodation to the victims of fraud than to those attorneys who 
represent them in these actions. Overall, NASAA believes that the 
key to fixing any inequities in the present system may be found in 
the exercise of judicial powers designed to curtail the riling of frivo- 
lous litigation and abusive fees, and in no way is this a problem 
endemic to securities laws. 

Q.2. A recent article in the Washington Post cited a study done by 
the big 6 accounting firms saying that they face $30 billion in li- 
ability claims. The article goes on to say that "the biggest problem, 
according to the industry, is the legal doctrine of 'joint and several 
liability,' under which any of the defendants in a lawsuit can be 
made to pay all the damages if others cannot." Legislative propos- 
als have been made to limit each defendants' liability to a propor- 
tionate share of fault which would address these concerns. What 
are the benefits/problems of this approach? 

A.2. Under Rule 10(b)(5), each defendant who conspires to commit 
a violation of the securities law is jointly and severally liable for 
all damages resulting from that violation. The doctrine of joint and 
several liability holds defendants in a securities fraud case respon- 
sible for the entire amount of damages if the other defendants are 
unable to pay their share. Under the proposal you have referenced, 
which would replace joint and several liability with a rule of pro- 
portionate liability, a judge or jury would specify what percentage 
of damages each defendant is responsible for paying. Supporters of 
proportionate liability have argued that the current system of joint 
and several liability is unfair because it forces parties with rel- 
atively less culpability to bear more than their share of the dam- 
ages. It also is argued by these individuals that joint and several 
liability encourages plaintiffs to join as many defendants in a case 
as is possible (particularly those that may be considered to have 
"deep pockets"), and forces defendants to settle weak claims in 
order to avoid disproportionate liability claims. 

When weighing the arguments of the defenders and critics of 
joint and several liability, it is important to remember that, above 
all else, the purpose of the current system is to protect the rights 
of defrauded investors. If forced to choose between innocent inves- 
tors who are victimized in a scheme and professionals who have 
knowingly or recklessly assisted the fraud by failing to meet profes- 
sional standards, the risk of financial loss rightfully is borne by the 
professionals, not the innocent victims. 



245 

Federal District Judge Stanley Sporkin, in his opinion in one 
savings and loan case, summed up the theory behind joint and sev- 
eral liability: 

Where were these professionals . . . when these clearly im- 
proper transactions were being consummated? Why didn't any of 
them speak up or disassociate themselves from the transactions? 
Where also were the outside accountants and attorneys when these 
transactions were effectuated? 
In a subsequent speech, Judge Sporkin elaborated: 

For this kind of massive, very sophisticated fraud to have oc- 
curred, it required the complicity of certain professionals that we 
all know of—CPAs, lawyers and appraisers. I'm suggesting that 
perhaps these professionals did not discharge their responsibil- 
ities to the broader public interest. 

NASAA would agree with the statement made in the testimony 
of William McLucas at the June 17th hearing, in which he asserted 
that, if the principle of joint and several liability is abandoned in 
favor of proportionate liability, the irony would be that investors 
would feel the greatest impact in precisely those cases involving 
the most meritorious claims. In sum, joint and several liability is 
important to protecting the rights of defrauded investors and 
should be preserved. 

Q.3. Some of the criticisms of the current system may not be mutu- 
ally exclusive. Indeed, while critics of the current system argue 
that steps should be taken to curb litigation, others have argued 
that other steps should be taken to facilitate investor lawsuits, 
such as lengthening the statute of limitations for securities fraud. 
Are these two criticism of the current system mutually exclusive? 
Or. should securities litigation reform and lengthening the statute 
of limitations be considered together? 

A.3. It is NASAA's view that Congressional consideration of the is- 
sues involved in lengthening the statute of limitations and the is- 
sues involved in securities litigation reform can, and indeed should, 
be considered separately. 

U.S. securities laws are well known for their complicated nature. 
It is rare that an issue arises that is as clear cut as that which 
calls for the lengthening of the statute of limitations in securities 
fraud cases. In the 1991 Lampf decision, the Supreme Court adopt- 
ed a uniform limitations period for private actions under Section 
10(b) of the Exchange Act and Rule 10(b)(5) thereunder. The limi- 
tations period requires investors to bring such actions within one 
year of discovery of the facts constituting the fraud, but not later 
than three years after the fraud occurs. As a practical matter, this 
unduly short leash for securities fraud private actions eviscerates 
the rights of investors to seek recovery from those who participate 
in knowing and deliberate fraudulent activity. Following the Lampf 
decision, NASAA for the past two years actively has supported leg- 
islation to lengthen the statute of limitations for securities fraud 
cases. 

Unfortunately, legislation to establish a longer statute of limita- 
tions for securities fraud claims has been derailed by successful ef- 
forts to pin it to the broader and more contentious 'litigation re- 
form" agenda. In testimony before the House Telecommunications 



246 



and Finance Subcommittee two years ago, I urged Congress 
sist the temptation to allow self-interested parties to stand a 



to re- 
temptation to allow self-interested parties to stand around 
the legislative pot and toss in amendments that were carefully cal- 
culated to poison the soup. At that time, Congress was considering 
legislation to lengthen the statute of limitations and to correct the 
Supreme Court's retroactive application of its decision in Lampf. I 
urged Congress to keep its focus on the only real issue that was 
on the table: small investors' need for a more reasonable statute of 
limitations than that which is allowed for under Lampf. Regret- 
tably, it was late in the session and the opponents of fairness for 
small investors were successful in bottling up the issue until the 
clock ran out. 

We would point out that allegations of abuse of the judicial proc- 
ess are not unique to securities law claims and that it is painfully 
obvious that the litigation reform proposals which have been put 
forward have generated intense, contentious and prolonged debate 
among Members of Congress and interested parties. If the issue of 
a reasonable and fair statute of limitations for small investors con- 
tinues to be held hostage to resolution of the litigation reform de- 
bate, those victimized by securities fraud will remain without rem- 
edy while the unrelated issues are hammered out. This simply is 
unacceptable. Congress can deal now with the unjust results of 
Lampf by putting in place a fair and uniform statute of limitation 
for 10(b) and 10(b)(5) cases. And, having done so, you still may de- 
vote future hearings and attention to the questions of litigation re- 
form, if it is determined that such an inquiry is warranted? 

In fact, we see no linkage whatsoever between the undocumented 
allegations of an explosion in frivolous litigation and the urgent 
need to lengthen the statute of limitations for securities fraud 
claims in the wake of Lampf. We fail to see how extending the stat- 
ute of limitations to, for example, five years, somehow would en- 
courage more spurious claims to be filed. If it is true, as been as- 
serted by reform proponents, that most frivolous cases are filed in- 
stantaneously with the push of a computer button whenever there 
is a drop in market price for a security, a three year statute of limi- 
tations (or, for that matter, a one year statute of limitation) will 
be no more effective in preventing frivolous cases than will a five 
year statute. NASAA strongly encourages Congress to move imme- 
diately on the issue of lengthening the statute of limitations for se- 
curities fraud cases. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SASSER 

FROM PATRICIA REILLY 

Q.l. Critics charge that too many cases are pursued with a view 
toward extracting settlements from corporations and other parties, 
without regard to the merits of a case, and that the settlements 
yield large fees for plaintiffs lawyers but compensate investors for 
only a fraction of their losses. What do you think of these charges? 
Are these abuses in the current systems? 

A.1. I have been involved as a shareholder in two securities class- 
action lawsuits, Pace Membership and Tucson Electric Power. Both 
lawsuits alleged fraud was committed by the companies' officers 
and directors which resulted in my losing money on my stock in- 
vestments. In Pace, I owned 200 shares and suffered a loss of 



247 

$1,517.51. In Tucson Electric, I owned 300 shares, and lost 
$5,596.56. 

Both cases settled for the directors' and officers' liability insur- 
ance, and nothing more. The wrongdoers did not pay a dime. 

In Pace I recovered $.17 on the dollar of losses. I was told by the 
accountants who administer the distributions in these cases that 
this was a large settlement. The accountants said that in the vast 
majority of the cases, the shareholders recover less than $.10 on 
the dollar of their losses. In Tucson Electric, I was told bv the 
shareholders' attorney to expect to recover $.05 on the dollar of 
losses. 

In Pace, the legal fees were over $3,300,000 in a $9,125,000 set- 
tlement. One lawyers charged $450 an hour. There was over 
$95,000 in xeroxing. In Tucson, the court awarded $7,500,000 in 
legal fees out of a $30,000,000 settlement. In Tucson, there were 
35 law firms, with 177 lawyers and 77 law clerks/paralegals rep- 
resenting the stockholders. The highest paid lawyer charged $500 
an hour, and 14 other lawyers charged between $400 and $500 an 
hour. 

Vincent O'Brien did a study of 533 securities class-action cases 
from April, 1988 to March, 1993. He found that 93 percent of these 
cases settle. Further he found that the cash amount of the settle- 
ment was 6 percent of the investors' total trading losses. 

If the purpose of the law is to (1) punish the wrongdoers and (2) 
compensate the investors for their losses caused by fraud, then 
these suits accomplish neither of these purposes. My experience is 
that the suits settle for insurance proceeds. The insurance pre- 
miums are not paid by the officers and directors who committed 
the fraud. Rather the premiums are paid by the company which 
passes these costs along to either its customers or its shareholders. 
As to the shareholder/victims, we recover virtually nothing. 

Mr. Lerach offered the testimony of Mr. Ramser and Mr. and 
Mrs. Billipp to say that the svstem worked. Mr. Ramser went to 
trial and as a result of the trial, the investors got 50 percent of their 
market losses back. In addition to that, the fraudulent defendant 
Mr. Sutliffe plead guilty to securities fraud. For Mr. and Mrs. 
Billipp, they got more than 60 percent of their market losses back, 
and again the defrauding defendants were convicted of a crime. For 
these three people, the system did work; but they are the rare ex- 
ception, not the rule. If you want more input, why not ask the 
thousands of people who are the norm that get 6 percent of their 
money back and see if they think the system works. 

I think it is obvious that there is abuse in the current system. 

Q.2. Some of the criticisms of the current system may not be mutu- 
ally exclusive. Indeed, while critics of the current system argue 
that steps should be taken to curb litigation, others nave argued 
that other steps should be taken to facilitate investor lawsuits, 
such as lengthening the statute of limitations for securities fraud. 
Are these two criticisms of the current system mutually exclu- 
sive? Or, should securities litigation reform and lengthening the 
statute of limitations be considered together? 

A.2. The focus should on curbing these empty settlements. The 
problem is not should there be more or less litigation or lawsuits. 



248 

The problem is the shareholders' claims are thrown out forever in 
these worthless settlements, which give nothing to the shareholders 
but make millions for their attorneys. 

The solution is to take away the incentive to settle if the inves- 
tors recover virtually nothing. My recommendation is to award the 
shareholders' lawyers the same percentage of the settlement fund 
as legal fees that the stockholders recover of their losses. If the 
shareholders get back 25 percent of their losses, then the lawyers 

f^et 25 percent of the settlement as legal fees. If the defendant is 
ooking at settling for 50 percent of the losses, the company will 
probably consider going to trial. However, if the shareholders only 
get 5 percent of their losses back in the settlement, then the law- 
yers only get 5 percent of the settlement fund as their legal fees. 
At this point, the shareholders' attorneys will probably consider 
going to trial since they would be getting so little in legal fees. I 
think this formula would produce more meritorious cases being 
filed in the first place, because now the prospect of going to trial 
and having to prove fraud is a real possibility. As it is now, the de- 
fendants agree to pay off a suit, good or bad, for 6 percent of the 
potential liability. Who wouldn't? 

I also think that if there is a settlement, the notice should tell 
the shareholders what they can expect to recover individually of 
their losses. The settlement notices give the lump sum. There is no 
explanation of what that means to the individual losses. The only 
thing that matters to a shareholders is how much will he be get- 
ting Dack of his losses, not how much is in the total fund. The no- 
tice should also tell the shareholders of the conflict of interest that 
their attorneys have in recommending the settlement, rather than 
going to trial. The notice should give a greater breakdown of the 
legal fees, i.e. hourly billing rate, etc. Also the attorneys should get 
paid their fees the same time their clients get their distribution. As 
it is now, the attorneys get paid shortly after the court approves 
the settlement, while the shareholders oftentimes have to wait 
years for the distribution. 

I do not think lengthening the statute of limitations does any- 
thing to protect the shareholders from these worthless settlements. 
You could make the statute of limitations 30 years, but if you do 
not do anything to correct these abusive settlements, the share- 
holders will still get sold out by their attorneys for $.06 on the dol- 
lar of losses while their lawyers make millions. The same holds 
true for "fee shifting" of legal costs, because in a settlement both 
sides can agree to any arrangement they want as to fees. It is the 
settlement process that needs to be fixed— do away with the incen- 
tive for the legal extortion which now exists. 

As I said in my letter to Senator Dodd, although Congress has 
passed a law to protect the shareholders from the fraudulent acts 
of officers and directors, what are you doing to protect the share- 
holders from the predatory practices of their attorneys? 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR BRYAN 
FROM DR. VINCENT E. O'BRIEN 

Q.l. You state that you have specialized in providing economic end 
financial analysis for "attorneys involved in complex litigation." Do 
you generally work for defendants in securities fraud cases? Please 



249 

provide the Subcommittee a breakdown by case of your work for 
plaintiffs or defendants. 

A.1. My work for attorneys involves many areas of the law and has 
been for both plaintiffs and defendants. Past cases are listed in my 
vita (attached). In the last year, I have worked on four plaintiff and 
five defendant matters. 

In the securities fraud area, I have worked on fourteen cases. 
Four were for plaintiffs and ten were for defendants. 

Q.2. You state that "93 percent of the securities class actions in my 
sample were settled out of court." How do you identify cases dis- 
posed of by Federal Rule 12(b)(6) and or 9(b) motions at the outset? 
How do you identify cases disposed of by summary judgment? Do 
you, in fact, pick up these cases at all in your sample? If not, isn't 
it more accurate to say that your 93 percent figure consists of cases 
not dismissed on motion or disposed of by summary judgment? 
Doesn't that mean that the 93 percent figure you use is not 93 per- 
cent of all cases files? 

A^. My source of cases is the Securities Class Action Alert. It 
reports new cases, updates existing cases, and provides settlement 
and other disposition information. I also searched the Lexis 
database for additional disposition data. 

If there was any settlement amount reported, the case was clas- 
sified as being "settled." Thus, if one defendant in a multi-defend- 
ant case settled, the case was classified as settled. If a matter was 
dismissed against all defendants, then it was classified as dis- 
missed. 

Additionally, I identified cases that had been reported as filed 
but for whicn there was no additional information on disposition. 
I then searched the Lexis database for this information. Cases that 
had had the class certification denied, that had been dismissed 
with prejudice, or that had been disposed of by summary judgment 
were classified as dismissed. 

As discussed in my response to the first set of questions to the 
Committee, 1 I believe that the 533 cases I examined are represent- 
ative of all of the cases filed. I further believe that indeed 93 per- 
cent of securities class actions filed are settled as defined above. 

Q.3. You state in your testimony that the norm for settlement in 
most other civil cases is only 60-70 percent. Please provide the 
Subcommittee with the basis for this statement and the specific 
studies that show this percentage of settlements in other civil 
cases. 

A.3. As I stated in my answers to the first set of questions from 
the Committee, "There are at least three such studies published in 
highly reputable legal journals. They are: 

Resnik, Judith, Tailing Faith: Adjudicatory Procedure in De- 
cline,' University of Chicago Law Review, Vol. 53, No. 2, Spring 
1986, p. 512. 

Kritzer, Herbert M., 'Adjudication to settlement: shading in the 
gray,' Judicature, Vol. 70, No. 3, October-November 1986, p. 163. 
iTubek, David M., et al., The Cost of Ordinary Litigation,' 
UCLA Law Review, Vol. 31, No. 1, October, 1983, p. 89." 



1 Answer to Question 3 of the July 7, 1993, letter from Mr. Riegle to Vincent E. O'Brien. 



250 

Q.4. You state that "fully 40 percent of the settlements in your 
sample were for less than $2.5 million. This is less than the de- 
fendants' cost of taking one of these cases to trial." What is the 
basis for this statement? Can you provide a figure on the cost of 
defense of a case through trial? 

A.4. I based this statement on my fourteen years of experience 
with complex litigation, on conversations with defendants' counsel, 
and on the data showing plaintiffs' attorneys' fees and expenses 
averaging $1,348,000 for settled cases. I also note that most of 
these cases involve multiple defendants with each incurring its own 
separate costs so that the combined defendants' costs would exceed 
plaintiffs' costs. 

Q.5. You state that "another 43 percent of the settlements were be- 
tween $2V2 and $10 million, and another 13 percent were between 
$10 and $20 million. These are the amounts of the typical insur- 
ance coverage by these firms. And in fact, settlements were often 
done for the insurance proceeds alone." Please provide the Sub- 
committee with documentation to support these statements. 

A.5. I based these statements on conversations with, and speeches 
by, defendants and plaintiffs' counsel, as well as insurance cov- 
erage data collected by The Wyatt Company of Chicago, Illinois. 
These data show that Directors and Officers insurance coverage 
averaged about $25 million from 1989 to 1991 with a median value, 
including non-profit corporations, of $15 million. These studies are 
proprietary and may be obtained from the publisher for a fee. 

Q.6. In your testimony you also state that "in civil cases, 30 to 40 
percent of all actions are terminated without trial or settlement." 
Please provide the Subcommittee with documentation to support 
the statement. Is there any study that has been done that supports 
this assertion? 

A.6. These figures are contained in the articles listed above in re- 
sponse to Question 3. 

VITA— Vincent E. O'Brien 

Position: President, The Marin Economic Research Institute, Inc. 

Affiliation: Principal, Law & Economics Consulting Group, Inc. 

Education: Harvard Graduate School of Business Administration, 
Doctor of Business Administration (1973). Studies focused on the 
use of quantitative and qualitative techniques in finance, business 
forecasting, strategic planning and industry analysis. 1970-1973. 
Harvard Graduate School of Business Administration. Master in 
Business Administration (1969). University of Illinois B.S. (1967) in 
Electrical Engineering with High Honors. Elected "Outstanding 
Senior in Electrical Engineering^ in 1967. Elected to Tau Beta Pi, 
Phi Kappa Phi, Eta Kappa Nu, Sigma Tau, and James Scholar 
Honoraries. 1962-1967. 

Professional Affiliations: American Economic Association, Na- 
tional Association of Business Economists, Financial Management 
Association. 

Professional and Business History: Putnam, Hayes & Bartlett, 
Inc., Managing Director 1983-1991. Dickenson, O'Brien & Associ- 



251 

ates, Inc., Director, 1978-1983. Economic and financial consulting 
as related to corporate strategy, industry regulation, antitrust en- 
forcement and commercial litigation. 

Cambridge Research Institute, Management Consultant. General 
business consulting, including financial strategy, industry analysis, 
corporate planning and litigation support. August 1977-June 1978. 
Bethlehem Steel Corporation, Corporate Economist, Planning De- 
partment. Had responsibility for economic analysis and forecasting 
for the U.S. economy and the domestic steel industry. October 
1973-August 1977. 

Management Consultant. Provided analytical and computer model- 
ing skills to several public and private clients. September 1970-Oc- 
tober 1973. 

Harvard Business School, Research Associate. Casewriting and 
teaching. September 1970-August 1972. 

McDonnell Douglas Astronautics Company, Market Analyst. Hun- 
tington Beach, California. Performed business analysis in space 
and civil systems markets. January 1969-July 1970. 

Litigation Expertise — Securities Cases 

James Almeida, et al. v. Bank of the West, et al.: Before the Supe- 
rior Court of the State of California, County of Alameda; on behalf 
of defendant, Michael G. Rafton; re damages. Deposed. Case favor- 
ably settled. 

Senatorial testimony: Before the Securities Subcommittee of the 
Senate Committee on Banking, Housing, and Urban Affairs, June, 
1993. 

Estate of Technical Equities v. Harry C. Stearns, et al.: Before the 
Superior Court for the State of California, in and for the County 
of San Francisco; on behalf of plaintiff; re stock manipulation. De- 
posed. Case favorably settled: Bear, Stearns & Co. agreed to pay 
$7 million to Technical Equities Corp., agreed to withdraw $20 mil- 
lion bankruptcy claims against Technical Equities, and to give up 
its right to cash proceeds from the company's estate. 

Ramtek v. Seidler Amtec Securities: Before the U.S. District 
Court, Northern District of California, on behalf of defendant; re 
damages in a class-action suit. Deposed. Case favorably settled. 

Congressional testimony: Before the Telecommunications & Fi- 
nance Subcommittee of the House Committee on Energy and Com- 
merce, 1991. 

In re Daisy Systems Securities Litigation: Before the U.S. District 
Court, Northern District of California, San Jose Division; re dam- 
ages. Case favorable settled. 

Wells Submission to the Securities and Exchange Commission: Re 
insider trading. Commission decided not to pursue any action. 

Alice Heideman and William B. Weinberger v. Xebec Corp., et al.: 
On behalf of defendant; re damages in a class-action suit. Case suc- 
cessfully settled. 

Edgar Dannenberg, et al. v. Towle Manufacturing Co.: On behalf 
of defendant; re damages in a class-action suit. 

M. Kornfeld, et al. v. First City: On behalf of defendant; re dam- 
ages in a class-action suit. 



7A-7A1 _ O/l 



252 

Marc Goldberg, et al. v. Americana Hotels & Realty Corp., Ameri- 
cana Hotels: On behalf of defendant; re damages in a class-action 
suit. 

Layman, et al. vs. Combs: Before the Court of the Northern Dis- 
trict of California; on behalf of plaintiff; re fraud in connection with 
the private placement of securities. Partially settled; partially tried. 

Richard Sharp, et al. v. Tymshare, Inc.: On behalf of defendant; 
re damages in a class-action suit. 

Arthur Schwartz, et al. v. Vector Graphic, Inc.: On behalf of de- 
fendant; re damages in a class-action suit. 

Frank Herzlin, et al. v. ITEL Corporation: On behalf of defend- 
ant; re damages in a class-action suit. 

Leonard K. Firestone, et al. v. Ameritrust: On behalf of plaintiff; 
re fiduciary duty by trustee, estimation of damages. 

Idanta Partners v. Ratner Clothes: On behalf of plaintiff; re secu- 
rities fraud, estimation of reasonable share price in the manage- 
ment buy-back. 

Litigation Expertise — Antitrust Cases 

Western States Promotions, American Publishers School Plan, et 
al. vs. Reader's Digest, QSP, Inc. et al.: Before Superior Court of 
the State of California, County of San Diego; re damages. Deposed. 
Case successfully settled. 

San Francisco Independent v. San Francisco Newspaper Agency, 
et al.: Before Superior Court of the State of California, City and 
County of San Francisco; on behalf of plaintiff; re allocation of costs 
and damages. Deposed. Favorably settled. 

Fiske v. Sullivan: On behalf of defendant, Diet Center; re market 
definition. Affidavit filed with successful summary judgment mo- 
tion. 

H&S Industries, Inc. v. Kaiser Aluminum & Chemical Corp., et 
al.: On behalf of plaintiff; re antitrust issues and damages. Damage 
study submitted. Case favorably settled. 

Conrac Corporation v. American Telephone and Telegraph: On 
behalf of plaintiff; re monopolization and damages. Preliminary 
damage study submitted. Case favorably settled. 

ITC Eastridge v. WaldenBooks, Inc.: On behalf of plaintiff; re 
market definition. Case favorably settled. 

National Railway Utilization Corporation v. American Associa- 
tion of Railroads, et al.: On behalf of defendant; re damages. 

Southern Pacific Communications Corporation v. American Tele- 
phone and Telegraph, et al.: On behalf of plaintiff; re damages. 

Fairchild Semiconductor Corporation, et al. v. Data General Cor- 
poration: On behalf of plaintiff; re damages. 

Docufde, Inc. v. Lockheed Electronics Corporation: On behalf of 
defendant; re damages. 

ILC Peripherals Leasing Corporation v. International Business 
Machines Corporation: On behalf of defendant; re damages. 

Memorex v. International Business Machines Corporation: On be- 
half of defendant; re damages. 



253 

Litigation Expertise — Intellectual Property Cases 

Aiasi v. Seagate: (Patent Infringement) Before the U.S. District 
Court, Northern District of California; on behalf of plaintiff. De- 
posed. Case successfully settled. 

Lewis Galoob Toys, Inc. v. Nintendo of America, Inc.: (Copyright 
Infringement) Before the U.S. District Court for the Northern Dis- 
trict of California, on behalf of plaintiff; re damages. Testified. 
Judge found fact and amount of damages sufficient to release $15 
million bond. 

Polaroid Corp. v. Kodak: (Patent Infringement) On behalf of de- 
fendant; re damages. 

Tencor Instruments v. Eastman Technology, Inc.: (Patent In- 
fringement) Before the U.S. District Court, Northern District of 
California; on behalf of defendant; re damages. Case favorably set- 
tled. 

Weldotron Corp. v. Hobart Corp., and Waldyssa, S.A.: (Patent In- 
fringement) Before the U.S. District Court for the District of New 
Jersey, on behalf of defendant; re damages. Deposed. Case success- 
fully settled. 

Litigation Expertise — General Cases 

Benziger Family Ranch Associates, dba Glen Ellen Winery vs. 
Bronco Wine Company, dba Classic Wines of California: Before the 
Superior Court for the State of California, in and for the County 
of Sonoma; on behalf of plaintiff; re damages analysis involving a 
terminated distributorship. Testified. Bronco Wine Company 
awarded $2.5 million for financial damages. 

Broadbase vs. Jiffy Lube: On behalf of defendant; re damages re- 
sulting from loss of area development agreement. Case favorably 
settled. 

Mark Berry, et al. vs. Dynasty Solar, et al: Before the Superior 
Court of California, County of Alameda; on behalf of defendants; re 
damages. Case settled. 

Arch Medical Associates, Inc. v. Nutrif System: Before Norfolk 
Superior Court, Commonwealth of Massachusetts; on behalf of de- 
fendant; re damages arising out of a franchise agreement in the 
weight loss industry. Testified. Jury reduced plaintiffs damages by 
three-fourths. 

Hahn-Lee v. Digital Equipment Corp.: Before the Superior Court 
of the State of California, County of Santa Clara; on behalf of de- 
fendant; re damages involving the sale of a computer in the motor- 
cycle parts business. Testified. Judge reduced plaintiffs damages 
by one-half. 

DeRosa v. Digital Equipment Corp.: Before the U.S. District 
Court, Northern District of California; on behalf of defendant; re 
damages involving the sale of a computer in the rack-jobbing indus- 
try. Testified. Jury found for our client. 

Hurlbut, Inc., v. Acurex Corp.: Before the U.S. District Court, 
Northern District of California; on behalf of plaintiff; re damages 
related to environmental contamination. Deposed. Case favorably 
settled. 

Unistrut v. GTE Sylvania: Before the American Arbitration Asso- 
ciation; on behalf of defendant; re damages involving the sale of a 



254 

company in the space-frame industry. Testified. Arbitrator adopted 
our position of no damages. 

Empire Tractor v. E.R. Bacon & Co.: Before the Superior Court 
of the State of California, County of Santa Clara; on behalf of 
plaintiff; re damages involving the sale of an equipment dealership. 
Testified. Jury awarded $400,000 in damages for our client. 

Mission National Insurance Company v. GTE Sprint Commu- 
nications Corp.: Before the U.S. District Court of Douglas County, 
Nebraska; on behalf of defendant; re damages involving provision 
of telecommunications services. Deposed. Case favorably settled. 

MKA v. U.S. Fidelity and Guarantee: Before the Superior Court 
of California, County of Fresno; on behalf of defendant; re damages 
involving insurance coverage in the fig processing business. De- 
posed. Case favorably settled. 

Above the Belt v. Wells Fargo Bank and The Taubman Co., Inc.: 
On behalf of defendant; re damages involving a lease in the retail 
industry. Deposed. Case favorably settled. 

Rehabilitation Technologies, Inc., RTI Middle, Inc. v. Smith Lab- 
oratories, Inc., Sutter Corporation: On behalf of defendant; re valu- 
ation of a company in the medical products industry. 

Eureka Federal Savings and Loan v. Ken Kidwell, et al.: On be- 
half of plaintiff; re breach of fiduciary duty and negligence, dam- 
ages. Case favorably settled. 

Dial-Net v. U.S. Telephone, Inc.: On behalf of defendant; re dam- 
ages for long-distance service reseller. 

Areata Corp. v. U.S.: (Condemnation Dispute) On behalf of plain- 
tiff; re damages. 

AT&T v. U.S. West: On behalf of defendant; re financial struc- 
ture of BOCs at divestiture. 

Tillie Lewis Estate: (Estate Settlement) On behalf of defendant; 
re business valuation. 

Litigation Expertise — Product Liability Cases 

Complex DES Litigation: Superior Court of the State of Califor- 
nia, County of San Francisco; on behalf of defendant; Emons Indus- 
tries; re snared product liability damages in the pharmaceutical in- 
dustry. Testified. Court adopted our methodology with modification. 

TRW v. GTE Sylvania: On behalf of defendant; re damages in- 
volving high technology light bulbs and space satellites. 

Wrongful Termination Cases 

Kohn vs. GTE Governmental Systems Corporation, et al.: On be- 
half of defendant; re review of damages in wrongful termination. 
Deposed. Case favorably settled. 

Gilbert R. Ashford v. The Dexter Corporation, Dexter Specialty 
Plastics & Composites Group, Jim Hensel, Does 1 through 50, In- 
clusive: Before the Superior Court of California, County of Contra 
Costa; on behalf of defendant; re prudent management. Deposed. 
Case favorably settled. 

Corcoran v. GTE Sprint Communications Corp.: Before the Supe- 
rior Court of California in and for the County of San Mateo; on be- 
half of defendant. Case favorably settled. 



255 

Lender Liability Cases 

California Micro Devices, Inc. v. Xerox Financial Services Cor- 
poration: On behalf of defendant; re damages in the micro proc- 
essor industry. 

AAI v. GECC: On behalf of defendant; re damages arising from 
a joint venture in the private jet industry. 

Victor Kacalek, Jr. etc. v. American Savings & Loan Association, 
Mason-McDuffie Investment Co. etc.: (Lender Liability) Before the 
Superior Court of the State of California, County of San Joaquin; 
on behalf of cross-defendant; re fraud, breach of fiduciary duty. 
Case favorably settled. 

Regulatory Testimony 

Application Nos. 85-01-034, 1.85-03-078: Before the Public Utili- 
ties Commission of the State of California on behalf of US SPRINT 
Communications Company; re Pacific Bell IntraLATA MTS rates. 

Application Nos. 83-06-65, Oil 83-04-02: Before the Public Utili- 
ties Commission of the State of California on behalf of GTE 
SPRINT Communications Corporation; re access charges; local 
transport and intercept rate structures. 

Application Nos. 83-01-22, 82-11-07, 83-06-65, Oil 83-11-07: 
Before the Public Utilities Commission of the State of California on 
behalf of intervenor, GTE SPRINT Communications Corporation; 
re access charges. 

Administrative Case No. 273: Before the Public Service Commis- 
sion of the Commonwealth of Kentucky on behalf of applicant, GTE 
SPRINT Communications Corporation; re jurisdictional reporting of 
telephone traffic. 

Docket No. 2415-NC-l: Before the Public Service Commission of 
Wisconsin on behalf of applicant GTE SPRINT Communications 
Corporation; re jurisdictional reporting of telephone traffic. 

Docket No. 83-0142: Before the Illinois Commerce Commission 
on behalf of applicant, GTE SPRINT Communications Corporation, 
re jurisdictional reporting of telephone traffic. 

Cause No. 29688: Before the Corporation Commission of the 
State of Oklahoma on behalf of GTE SPRINT Communications Cor- 
poration; re blocking of or compensation for unauthorized 
IntraLATA traffic. 

Cause No. 28309: Before the Corporation Commission of the 
State of Oklahoma on behalf of GTE SPRINT Communication Cor- 
poration; re lump-sum NTS cost recovery plans. 

Cause No. U-^5-23, et al.: Before the Washington Utilities and 
Transportation Commission on behalf of GTE SPRINT Communica- 
tions Corporation; re lump-sum NTS cost recovery plans. 

Cause No. U-85-26: Before the Washington Utilities and Trans- 
portation Commission on behalf of GTE SPRINT Communications 
Corporation; re AT&T WATS rates. 

Publications, Speeches & Seminars — Articles 

"The Class-Action Shakedown Racket," THE WALL STREET 
JOURNAL, September 10, 1991; with Richard W. Hodges. 

"Economic Damages Under California's Right of Publicity Law," 
with Lynne Klein; unpublished draft, 1991. 



256 

"The Elements of a Lost Profits Damage Claim," THE NA- 
TIONAL LAW JOURNAL, January 29, 1990; with Joan Meyers. 
"Some Suggestions on the Effective Use of Experts," 1988. 

Cases 

Donna Taylor v. Shape-Up Stores with Betsy Lear and Henry 
Hecht, 1989. 

A Note on Input-Output Analysis, Harvard Graduate School of 
Business, 1972. 

Various business cases for Harvard Graduate School of Business, 
1970-1973. 

Speeches & Seminars 

Panel member, Expenses in International Patent Litigation, Stan- 
ford Law School, Law & Technology Conference, May 1 and 2, 
1992. 

Panel member, The Bottom Line on Damages: Soft Proof and 
Hard Problems, before the American Bar Association Section of 
Litigation, Chicago, October 24-26, 1991. 

Economic Damages Under California's Right of Publicity Law be- 
fore the California Judges Association and the Intellectual Property 
Section of the California Bar Association, Los Angeles, 1991. 

The Efficient Market Model: Basic v. Levin son at the Putnam, 
Hayes & Bartlett, Inc. annual law and economics seminar, Phoenix, 
1988. 

Seminars Organized 

The Efficient Market Model: Where is it Taking Us, 1990. 
Polaroid v. Kodak: A New Damages Approach, 1990. 
California Insurance Reform and a Reasonable Rate of Return, 
1990. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DOMENICI 

FROM DR. VINCENT O'BRIEN 

Q.l. Please comment on the study of class-action settlements sub- 
mitted by Mr. Radetich. 

Q.2. Please comment on the studies of class-action settlements sub- 
mitted by Mr. Lerach. 

A.1. & AJ2. The studies submitted by Mr. Radetich and Mr. Lerach 
are closely intertwined. They both appear to differ from mine in 
two areas: (1) data on attorneys' fees, and (2) data on class recover- 
ies. These are discussed below. 

Data On Attorneys' Fees 

In my study, I indicated that attorneys' fees ". . . can be as high 
as a third of the recovery. . . ." Mr. Lerach presented data from 
Class Action Reports snowing ". . . that attorneys' fees — and 
costs — have averaged only 15.2 percent of all recoveries." Finally, 
Mr. Radetich presented data that implied that attorneys' fees, 
costs, and the costs of distributing the funds were 20 percent of re- 
coveries. 

While these statements may appear to be contradictory, they are 
not. Each could be true without necessarily contradicting the other. 



257 

Indeed, the following analysis of the underlying data demonstrates 
how the various interests can be reconciled. 

My study collected attorney fee data from individual case reports 
in two ways. For 238 cases, attorney fee data were expressed as an 
amount "not to exceed" a certain percentage of the recovery. The 
most common percentage was 33 percent and this was the basis for 
my statement. However, for fifty-nine cases, the actual amount of 
attorney fees awarded by the court was reported. These were $62.9 
million on $276.8 million in settlements or 22.7 percent of settle- 
ments. Cost awards were available for eighty-one cases. These were 
$18.0 million on $508.4 in settlements or 3.5 percent of settle- 
ments. Thus, my study indicates an average award of fees and 
costs of 26.2 percent. 

The study done by Class Action Reports, upon which Mr. Lerach 
relies, covers 334 securities cases of all types from 1973 to 1990. 
The summary data presented with Mr. Lerach's testimony (Exhibit 
3 in his testimony, attached here as Exhibit 1) do not allow for an 
in-depth comparison, but one thing is clearly shown: large cases 
have much smaller fee awards than smaller ones. Fee awards 
range from 25.2 to 28.6 percent in the six categories of cases with 
aggregate class recovery under $20 million. It is only for the 32 
cases (10 percent of the total) with aggregate class recovery above 
$20 million that lower awards were found. This suggests the possi- 
bility that a few unusual cases distorted the results. The author of 
the study acknowledges that "... a relatively few *big cases' domi- 
nate the entire sample." x For the 90 percent of the cases with re- 
coveries under $20 million, the average fee award was 27.0 percent. 
This is substantially in agreement with my finding of 26.2 percent. 

The study done by Mr. Radetich examines 69 securities class ac- 
tions in which his firm had been hired as the class administrator. 
It indicates that ". . . 79.5 percent of the gross settlement funds, 
for these matters, have been distributed to class members." By sub- 
traction, this implies that 20.15 percent of the funds go for attor- 
neys' fees, costs, and the costs of administering the payout. 

To my knowledge, the data presented by Mr. Radetich have 
never before been made public. While they are an important addi- 
tion now, Mr. Radetich's analysis suffers from two errors. When 
these are corrected, his data also show fees and costs in the 30 per- 
cent range. 

The first of these errors is that the data include a very large re- 
covery, the Boesky disgorgement, that was obtained by the SEC. 
None of the settlement funds went to attorneys. Including this case 
in the database is not correct and it distorts the results. Eliminat- 
ing this one case yields a fees and costs percentage of 22.4 per- 
cent. 2 

The second error is that Mr. Radetich includes the interest 
earned on the settlement fund when performing his calculations. 
As it often takes years for the final payout to occur, this interest 
can be a significant amount. For example, a $100 settlement in 
which the attorneys were paid a 26 percent fee would yield a fund 
of $74. If this were invested at 10 percent for two years, it would 



1 Class Action Reports, "Attorney Fee Awards in Common Fund Securities & Antitrust Class 
Actions," July-August, 1990. 

3 Mr. Hefner's data and these calculations are shown in Exhibit 2. 



258 

grow to $89.54. Mr. Radetich would report that as an 89.54 percent 
payout implying that attorneys' fees and expenses amounted to 
only 10.46 percent. 

Clearly, this approach distorts the picture. By eliminating this 
interest, values directly comparable to those in my study can be 
achieved. 3 Using Mr. Radetich's data with estimated interest elimi- 
nated, indicates that attorneys' fees and costs averaged 30 percent 
for the 68 cases examined. 4 Thus, Mr. Radetich's data do not con- 
flict with my study. Instead, they support the same conclusion that 
attorneys' fees and costs, on average, reduce the class settlement 
fund by upwards of 26 percent. 

Data on Class Recoveries 

In my study, I randomly selected twenty cases and found that 
"On average, the cash amount of the settlement was six percent of 
the total trading losses. ..." I also cited another study 5 of 49 
cases in which settlements ". . . amounted to approximately three 
percent of shareholder losses." In contrast, Mr. Lerach calculated 
that u . . . claimants receive about 60 percent of their recoverable 
damages after attorneys' fees." 6 

Mr. Lerach arrives at a higher recovery for three reasons. First, 
he makes a very large adjustment for the difference between mar- 
ket losses and provable damages. Second, he relies on data that 
contain an error in addition. Third, he uses the wrong data. These 
are discussed in order below. 

First, Mr. Lerach takes Mr. Radetich's data on market losses and 
reduces it to 27.7 percent of its original amount to arrive at prov- 
able damages. He bases this adjustment on a analysis of 20 cases 
by the leading plaintiffs' expert, John Torkelsen. 7 Mr. Lerach then 
divides Mr. Radetich's data on distributions to claimants by this 
amount to calculate a high payout to claimants. 8 

In other words, Mr. Lerach is contending that there is a big dif- 
ference between investors' market losses and the provable damages 
and that I haven't taken this into account. That simply is not the 
case as I have taken this into account. Both my analysis and the 
one I cite utilize the standard damages model developed by Mr. 
Torkelsen. This model was run using the standard adjustments for 
market effects used by plaintiffs in most securities cases. Thus, my 
analysis (and the one I cite) take into account any differences be- 
tween investors' market losses and the damages plaintiffs were 
likely to assert at trial. 

I cannot say why these calculations yielded results different from 
those in Mr. Torkelsen's statement. I can only repeat that I have 
replicated Mr. Torkelsen's damages model and methods and this 



3 The interest should be excluded because it does not represent compensation for the fraud. 
Instead, it is payment to the class waiting for the distribution. The class receives no more by 
waiting for the distribution after interest has accrued than it would if payment had occurred 
immediately and the class members had invested the funds themselves. Also, it does not rep- 
resent any contribution by the attorneys. 

4 These calculations are explained in Exhibit 3 and shown in Exhibit 2. 

"Frederick C. Dunbar, Senior Vice President, National Economics Research Associates, Inc., 
Recent Trends In Securities Class Action Suits, August, 1992. 

8 While Mr. Lerach relied upon Mr. Radetich's data, Mr. Radetich stated that he was unable 
to ". . . tell the Committee what percentage of a class member's damages are on average recov- 
ered in these cases." 

7 Exhibit 1 of Mr. Lerach's prepared testimony. 

•Mr. Lerach's calculations are given in Exhibit 2 of his testimony. 



259 

yields payouts of less than 6 percent. There are several possible ex- 
planations for the differences. First, the data on distributions to 
claimants is overstated by the inclusion of the Boesky 
disgorgement and the interest earned by investing the settlement 
fund pending distribution, as discussed above. Second, Mr. 
Torkelsen states that his damages numbers were prepared "... to 
be used in testimony." This is usually late in the litigation process 
and may be after several revisions. My estimates are based on the 
type of study that plaintiffs provide early in the litigation process. 9 
Finally, I note that Mr. Torkelsen's results are heavily influenced 
by a few very large cases. As shown in Exhibit 4, three cases with 
the lowest percentage of damages to market losses account for 62 
percent of the total losses. 

The second reason for Mr. Lerach's high payout ratio is his reli- 
ance on Mr. Radetich's inflated data on distributions to claimants. 
I have already discussed how the inclusion of the Boesky 
disgorgement and the inclusion of interest earned on the fund 
while awaiting distribution overstate these numbers. In addition, 
Mr. Radetich makes an addition error that overstates distributions 
by $320,000 which Mr. Lerach incorporates in his analysis. 

The tnird reason for Mr. Lerach s high payout ratio is that he 
uses a second study by another settlements firm, Gilardi & Co. The 
only reference to this study is in his Exhibit 2. None of the under- 
lying data have been provided as were the Heffler & Co. data and 
no one from Gilardi & Co. has appeared before the committee. 
Thus, I can not comment on the validity of that study. 

I can state, however, that it has a major impact on the results. 
If Mr. Lerach's methodology is applied to just the Heffler & Co. 
data, as I have done in Exhibit 5, the payout ratio falls from 60 
percent to 39 percent! If the Heffler & Co. data are adjusted for the 
problems discussed above, the payout ratio declines to 17.4 per- 
cent. 10 

Thus, while there appears to be some room for disagreement on 
the exact percent of damages that plaintiffs recover, there does 
seem to be a consensus that it is a small fraction of their damages, 
however calculated, and an even smaller percentage of their mar- 
ket losses. 

Q.3. During his testimony, Mr. Lerach stated that your study was 
skewed because it relied on a database that reports only settlement 
of class actions. He also stated that there is no support for the as- 
sertion that the settlement rate for civil litigation generally is ap- 
proximately 60 to 70 percent. Please respond to these statements. 
A.3. There are two parts to this question: (a) bias in the source 
data, and (b) disposition of other cases. The answers follow. 

Bias in the Source Data 

In his oral testimony, Mr. Lerach suggested that my primary 
data source, Securities Class Action Alert, was biased toward 
cases that were settled. Thus, my conclusion that 93 percent of the 
cases settled was misleading. Tnis criticism of the database was 



e Since virtually all of these cases settle, I felt that this number best represented the plaintiffs' 
position. 

10 The effect of each of these individually is shown in Exhibit 6. 



260 

specifically denied by the editor of Securities Class Action 
Alert in the July 1993 issue when he wrote, 

"There has been criticism of the information in Securities 
Class Action Alert as being a collection of settled cases, this 
is simply ludicrous. The current issue, July 1993, contains infor- 
mation on 34 cases that were settled or dismissed. In addition, 
17 new cases are covered, including a suit filed against U.S. 
HomeCare Corp. that was filed just two weeks ago and has not 
been reported anywhere else!" 1X 

I have also checked this data source in several different ways 
and have not found any biases. First, I contacted the editor and 
discussed the methods by which the cases were identified and re- 
ported. I did this on more than one occasion and found the methods 
to be reliable and unbiased. Second, I circulated a copy of my origi- 
nal study to over 100 attorneys involved in securities class actions, 
including the leading plaintiffs' attorneys, and asked them to notify 
me of any omissions. Finally, I checked my list of cases with other 
sources, including Class Action Reports and published court or- 
ders. From this, I believe that the 533 cases I examined are rep- 
resentative of all of the cases filed and are not biased toward set- 
tlements. 

I would also like to point out that the results of my study have 
been shown to be stable over time. The first study was completed 
in 1991 using 332 cases. At that time, disposition data had been 
reported on 191 of them. After the initial study was released, dis- 
position data on approximately 84 of the remaining 141 cases were 
reported. These new data also showed a high settlement rate. 

The study was then updated to the present by adding 201 new 
cases, of which 82 had disposition information. Again, the study 
showed a high settlement rate among the new cases with disposi- 
tion information. With disposition data on 353 cases over a five 
year period, I am quite confident that the 93 percent settlement 
rate reported in my study is accurate. 

Sources of Disposition Data on Other Litigation 

In my testimony I compared the 93 percent settlement rate to a 
norm of 60 percent to 70 percent in other civil cases. Also, I indi- 
cated that typically over 30 percent of cases are dismissed or 
dropped. In his oral testimony, Mr. Lerach indicated that he knew 
of no study of case disposition indicating a 60 percent to 70 percent 
settlement rate. 

There are at least three such studies published in highly reputa- 
ble legal journals. They are: 

Resnik, Judith, "Failing Faith: Adjudicatory Procedure in De- 
cline," University of Chicago Law Review, Vol. 53, No. 2, Spring 

1986, p. 512. 
Kritzer, Herbert M., "Adjudication to settlement: shading in 

the gray," Judicature, Vol. 70, No. 3, October-November 1986, p. 

163. 
Trubek, David M., et al, "The Cost of Ordinary Litigation," 

UCLA Law Review, Vol. 31, No. 1, October, 1983, p. 89. 



11 James M. Newman, Securities Class Action Alert, July, 1993, p. 38. 



261 

Q.4. Some witnesses testified that the decline in the number of 
class-action suits reported by the Administrative Office of the U.S. 
Courts, and the asserted lack of any increase in such suits over the 
last twenty years, indicates that there is no need for action by the 
Congress. Do you agree? 

A.4. Absolutely not. As I pointed out in my testimony, these cases 
are quite common and costly. Yet, they return very little to the in- 
vestors and, in at least 90 percent of the cases, provide virtually 
no deterrence. Even if the number of these cases filed has leveled 
off, there is a serious problem of economic waste and inefficiency. 
My consulting practice involves almost every type of corporate 
litigation. In my opinion, the one area most in need of reform is 
securities class-action litigation. 



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269 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SASSER 
FROM WILLIAM S. LERACH 

Q.l. Critics charge that too many cases are pursued with a view 
toward extracting settlements from corporations and other parties, 
without regard to the merits of a case, and that the settlements 
yield large fees for plaintiffs lawyers but compensate investors for 
only a fraction of their losses. What do you think of these charges? 
Are there abuses in the current system? 

Introduction 

A.1. As I testified, any abuses in the current system can be ade- 
quately addressed by, the courts. There are strong arguments for 
strengthening the system of private remedies. The charges that the 
critics make are false. They are offered by a coalition of large ac- 
counting and law firms and public companies many of which have 
been implicated in major securities frauds in recent years and want 
to see the system of private enforcement which underlies the secu- 
rities laws weakened. When meritless or frivolous cases are filed 
the courts have adequate tools — early dismissal, prompt summary 
judgment and sanctions — to protect the defendants and punish the 
plaintiffs' counsel. 

The Merits Do Matter 

A few critics have claimed that the merits of securities class ac- 
tions do not matter — they are always settled for a small fraction of 
the damages thus permitting the lawyers to get paid well while 
class members get little. This is not true. 

Increased Dismissals And Summary Judgments Indicate Meritless 
Cases Are Identified And Disposed Of 

Defendants faced with a securities class-action suit are not help- 
less. Nor are the courts powerless to deter frivolous filings. In fact, 
securities lawsuits which lack merit are promptly dismissed for 
failing to plead a case (Rule 12(b)(6)), for failing to plead fraud with 
particularity (Rule 9(b)) or disposed of by summary judgment (Rule 
56) and Federal courts increasingly impose sanctions (Rule 11) on 
attorneys who file frivolous suits. 

Access to justice for those victimized by fraud is a cornerstone of 
our judicial system and a right provided by the anti-fraud provi- 
sions of the securities laws. The real issue is how to deal with 
meritless or frivolous lawsuits. Can meritless suits be promptly dis- 
missed? Are those who file frivolous lawsuits punished? If the an- 
swer to these questions is yes, it would appear that the current 
system is, in fact, separating wheat from chaff, thus permitting in- 
vestors victimized by fraud who file well-pleaded claims from going 
ahead on the merits while at the same time, protecting defendants 
from having to defend meritless claims and inflicting appropriate 
punishments on those who abuse the litigation process by filing 
frivolous claims. 

There is widespread agreement that in recent years courts have 
been more willing to dismiss securities fraud lawsuits on the plead- 
ings: 



270 

"In recent months a number of other companies from high-tech 
to banking have had unusual success in defending charges they 
defrauded investors. ... A growing number of private cases 
seem to be dying early deaths. I think it is a discernible trend," 
says Janet Cooper Alexander, a Stanford Law Professor. 

• * * 

Lately, some judges have been invoking a procedural rule that 
requires shareholders' attorneys to allege specific acts of fraud, 
beyond insider trading or evidence of a stock plummeting in 
value as part of their initial court filings. Judges are also re- 
sponding to a 1986 U.S. Supreme Court directive to grant sum- 
mary judgment before trial more often in cases where the facts 
aren't in dispute. More important, some judges are dismissing 
cases without giving shareholders' attorneys a chance to probe 
company files for damaging evidence to support their claims. 
"More Companies Succeed In Defending Charges They Defrauded 

Investors," Wall St. J., April 30, 1992, B-l. 1 
A leading lawyer for defendants in securities cases has recently 

written that "Federal courts have displayed a striking willingness 

to dismiss these suits." 

A few years ago, the tide of legal liability sweeping American 
business seemed ready to burst into the boardroom with a flood 
of shareholder class-action suits. However, a series of court deci- 
sions could have directors breathing a little easier — especially if 
they follow a few common sense rules. 

Source: Pitt & Groskaufmanis, "Directors' Liability: No Fraud By Hindsight, Tips 
for Taking the Sting out of Shareholder Suits',* Jan./Feb. 1993 The Corporate 
Board, The Journal of Corporate Governance. 

^ Rule 11 permits courts to impose sanctions on any attorney who 
files a frivolous suit. Courts are quite willing, where appropriate, 
to impose Rule 11 sanctions for frivolous securities fraud suits. 
Courts have imposed Rule 11 sanctions in securities cases as high 
as $294,000. 

What is going on here is good— judicial evolution. As SEC Com- 
missioner Richard Roberts has stated: 

I am concerned that the securities litigation reform legislation 
under consideration in Congress, if enacted, would achieve re- 
form at the expense of existing protections against deliberate 
fraud and would make it impossible for many defrauded losses. 
Thus, I have not supported the legislative securities litigation re- 
form efforts underway to date. 

I argue that it is difficult to make the fine, qualitative judg- 
ments necessary to sift out the meritless securities litigation 
from all securities litigation either by rule or by statute. I believe 
that such a process can be better handled by the judicial system 
itself. In fact, I submit that litigation reform is presently being 
conducted by the Federal judiciary. I further submit that pro- 
ponents of litigation reform may be better served by encouraging 
the continuation of the judicial reform that has occurred to date 



1 A recent study by the National Economic Research Associates, Inc. concluded: ". . . the per- 
centage of cases dismissed has also increased significantly." Dunbar, "Recent Trends In Class 
Action Lawsuits," August 1992. 



271 

rather than to engage in the pursuit of well intentioned but ill- 
fated legislative reform. 

For an example of such judicial reform, I would point out that 
the Supreme Court's recent decision in Reves v. Ernst & Young 
narrows substantially the exposure of accountants and other pro- 
fessional advisers to RICO liability. The Reves decision should di- 
minish the exposure of professional advisers to liability under 
RICO. Reves follows a number of recent decisions in favor of ac- 
countants that indicate that the pendulum of liability had swung 
too far against accountants and is now beginning to return more 
toward the center. This judicial trend should be a positive devel- 
opment for securities litigation reform. 

Further, earlier this month, the Supreme Court held that a 
right of contribution is available in private actions under Section 
19(b) and Rule 10(b)(5). a result urged by the Commission in an 
amicus curiae brief filed with the Court. 

Moreover, Rule 11 sanctions are now being imposed more fre- 
quently against both plaintiffs and defendants for taking 
meritless positions in litigation. 

"Litigation Reform, Simplification, and Internationalization," Re- 
marks of Richard Y. Roberts, Commissioner, U.S. Securities and 
Exchange Commission before the OCA Alumni Meeting, Washing- 
ton, DC, June 28, 1993, pp. 2-3 (footnote omitted). 

Strong Cases Result In Large Recoveries Or Verdicts For Victims 

To believe that the merits do not matter, i.e., class-action law- 
suits are routinely resolved regardless of their merit, you must be- 
lieve that none of the checks and balances in the legal system func- 
tion properly and that no one in the process performs their jobs 
properly: the plaintiffs' lawyers (many of whom are leading mem- 
bers of the bar, authors and lecturers) are apparently just shake- 
down artists, the defense lawyers (who are highlv skilled and well- 
paid) apparently cannot tell a good case from a bad case or do not 
care, and Federal judges (independent, life-time appointees), appar- 
ently ignore their duties under Rule 23 to approve class-action set- 
tlements only if they are fair to the class. Tnis simply cannot seri- 
ously be maintained. 

The assertion that securities class actions are virtually never 
tried is contrary to experience. Many class-action cases have also 
been tried to verdict — Melridge (plaintiffs won); Lincoln Savings 
(plaintiffs won); Nucorp Energy (defendants won); Apple Computer 
(plaintiffs won; judge took away verdict); Data Point (plaintiffs 
won); Polaroid (plaintiffs won; appellate court reversed); Northwest 
Industries (plaintiffs won); Viatron Computer Systems (plaintiffs 
won); Marathon Oil (defendants won); Dolly Madison (plaintiffs 
won); Continental Illinois Bank (defendants won); Solitron Devices 
(plaintiffs won); United States National Bank (plaintiffs won)— and 
there are many more. 

Good cases produce good recoveries. Securities class actions have 
produced many large recoveries for victims all over the United 
States. WPPSS— $700+ million; Lincoln Savings— $200 million; 
Shell Oil— $183 million; L.A. Gear— $50+ million; U.S. Financial— 
$50 million; Financial Corp. of America — $32 million; Wickes— $32 
million; VMS— $66 million; Itel— $40 million; Equity Funding— $60 



272 

million; Oak Industries — $32 million; Nucorp Energy — $60 million; 
LILCO — $50 million; Ames Department Stores — $42 million; U.S. 
National Zfcmfc— $27 million; Baldwin-United — $183 million; Walt 
Disney — $45 million; Network Eguipment — $21 million; Genen- 
tech-f$29 million; Software Toolworks — $26.5 million; Warner Com- 
munications — $18 million; Pepsico— $18 million — and there are 
many more. 

Recent Studies of Class Actions Show These Cases Are Producing 

Good Recoveries For Victims 

Studies by Heffler and Company and Gilardi & Company, the 
two largest class-action claims administrators, of the recoveries and 
distributions in 173 class actions were submitted to the Committee 
and are included herewith as Exhibits 1 and 2. Set forth below are 
summaries of those two studies: 



Claims Administrator 


Cases 


Total 
Claims 


Total Recoveries 


Total Market 

Losses 


Percent 
of Market 
Loss Re- 
covered 


Hefiler & Co 


69 
104 
173 


271,615 
694,111 
965,726 


386,000,000 
2,200,000,000 
2,586,000,000 


2,800,000,000 

7,700,000,000 

10,500,000,000 


13.5% 


Gilardi & Co 


29.0% 


TOTALS 


24.6% 



These results provide a strong confirmation that securities fraud 
class-action cases are generating significant recoveries of investors' 
market losses (as opposed to their legally recoverable damages). 

Of course the securities laws only permit a defrauded investor to 
recover that portion of his market or investment loss which was 
proximately caused by the fraud. In order to attempt to estimate 
what percentage of class members' recoverable damages are being 
recovered in these cases, Princeton Venture Research prepared a 
study on recent settlements in an effort to determine on average 
what percentage of the market losses in a given case are actually 
potentially recoverable damages. Princeton Venture's data, which 
was submitted with my testimony to the Committee and is in- 
cluded herewith as Exhibit 3, concludes that on the basis of review- 
ing these recent cases, recoverable damages in securities class-ac- 
tion cases on average are approximately 27.7 percent of market 
losses. Therefore, applying Princeton Venture's results to the totals 
of the Gilardi and Heffler studies we conclude that in those 173 
cases for which the claims administrators have data, the poten- 
tially recoverable damages were approximately 27.7 percent of the 
$10.59 billion in market losses or $2,935 billion. Thus, in those 
cases, the distribution of $1.75 billion represents a distribution of 
60 percent of the classes' recoverable damages, after fees and ex- 
penses were paid. 

Attorneys' Fees In Class Actions 

The most comprehensive study ever done of attorneys' fee awards 
in class actions, performed by the authoritative Class Action Re- 
ports, studied 404 class-action cases involving recoveries aggregat- 
ing $6.3 billion. That survey concluded that fees and costs in those 
404 cases averaged 14.8 percent of the recovery. These amounts are 
well below the fee percentage of 33 percent, which is the "market 



273 

rate" for contingency fees, not including expenses. When limited to 
the 334 securities class-action cases included in the study where 
$4.2 billion was recovered, the fee and expense award was just 15.2 
percent of the recovery. Copies of this study have previously been 
submitted to the Committee. 

Substantial procedural safeguards exist to control the award of 
attorneys' fees in securities class actions and protect class mem- 
bers: 

• Fees are paid only out of the recovery. If there is no recovery, 
the attorneys get no fee. 

• Plaintiffs' counsel must advance the costs — which can be very 
substantial — to fund the prosecution of the case. Class members 
are not required to put up any money. 

• No fee or expense reimbursement can be awarded without notice 
to the class of the amount sought and a hearing at which they 
can object in writing or in person. 

• As many of the class members are institutional investors with 
large claims, i.e., a significant stake, who are repeat claimants, 
they have a real incentive to monitor this process and partici- 
pate. 

• No fee or expense reimbursement can be made except by the 
Federal judge who has overseen and managed the litigation. 

Fees awards in class actions are quite modest and have actually 
declined in recent years: 

There is a tremendous fear on behalf of judges that they will 
be seen as giving unjustified windfalls to plaintiffs' attorneys," 
says John Coffee, a Columbia University law professor. 

Source: "Shareholder Suits Pay Attorneys Less," Wall St. J., Feb. 1, 1992. 

Complaints By Ms. Reilly That Class Members Receive Tiny 
Recoveries Of Their Damages Are Incorrect 

The only class member to come forward and complain about the 
levels of recoveries in class actions at the Committee's recent hear- 
ing was Ms. Patricia Reilly. 

Reilly's primary complaint is that class members in securities 
class actions do not receive large enough recoveries when settle- 
ments occur. To the extent her complaint is correct, the remedy is 
to strengthen — not weaken — the remedies available to allegedly de- 
frauded investors so they can recover more. 

Reilly claims stockholders only get 5 cents on a dollar of their 
market loss in these cases and that the wrongdoing officers and di- 
rectors pay nothing. She is wrong. 

• The Heffler and Gilardi studies show that shareholders receive 
almost 25 percent of their market losses and about 60 percent of 
their legally recoverable damages after deduction of attorneys' 
fees. 

• In many cases, shareholders recover over 50 percent of their 
market losses (for example, in the Lincoln/ACC case, investors 
will ultimately recover nearlv 100 percent of their damages). 
The rights of all class members — including Reilly — are well pro- 
tected by the system. In accordance with class-action rules, they re- 
ceive notice of every proposed settlement and fee application of 



274 

plaintiffs' counsel in every class action and have an opportunity to 

appear and object. 
In Pace Membership, Reilly objected to a $9 million settlement 

and an attorneys' fees request of 33 percent. The court considered 

her written objections, permitted her to inspect plaintiffs' counsel's 

records, heard argument from her and found her objections were 

unwarranted. 
Judge Nottingham in Pace, in response to Reilly's objection that 

she was getting only 15 percent of her loss, noted: 

I guess part of the problem is that nothing would be going to 
your pocket if it weren't for the plaintiffs' attorneys . . . You and 
the other class members have to recognize: (1) that your market 
loss is not the actual damage that you d be able to prove in court 
anyway; (2) that if you'd gone to court, you have a substantial 
risk of either recovering a much lesser amount based on defend- 
ants' damage theories or nothing at all if you lost on liability. 

After obtaining from Ms. Reilly the information that she had in- 
vested approximately $3,000 in Pace Membership, Judge Notting- 
ham stated: 

Alright. So, if it weren't for the class-action device and plain- 
tiffs' counsel, would you have been able to sue for any part of 
that $3,000, retained your own attorney, and come to court? 

Ms. Reilly: No. . . . 
Reilly also objected to a $30 million settlement in Tucson Electric 
and an attorneys' fee request of 30 percent. The court permitted 
her to appear and argue, in addition to submitting written objec- 
tions. The court approved the settlement and awarded a reduced 
fee of 25 percent. Nevertheless, Reilly has appealed and tied up 
this settlement, thus depriving thousands of class members of an 
ability to obtain their share of this multi-million dollar class-action 
settlement which, but for her appeal, would have been distributed 
long ago. 

The Number Of Securities Class Actions Filed Has 
Remained Constant While Stock Offerings And Trading Have 

Greatly Increased 

There is no factual basis for the claim that recent years have 
seen an "explosion" in securities class-action suits. A review of the 
relevant data indicates that while the number of securities class 
actions filed has risen in the last three years the number of class 
actions currently being filed is just about the same as the number 
that were being filed 20 years ago. According to the Administrative 
Office of the U.S. Courts, in 1973, 1974 and 1975 there were 
235,305, and 258 securities class-action suits filed. By comparison 
in 1990, 1991 and 1992 there were 315,299, and 268 such suits 
filed. On the other hand, during the same 20 year period initial 
public offerings of stock, all common stock offerings, and stock mar- 
ket trading volume (measured by dollar value of the trades or 
shares traded) have all increased exponentially. The enclosed black 
binder (Exhibit 4) "Statistical Information: Public Offerings Stock 
Trading and Class Actions" contains a series of charts demonstrat- 
ing all of these trends and their inter-relationships. You will see 
from these charts that the only "explosion" that has occurred in 



275 

this area in the last 20 years has been an "explosion" in initial pub- 
lic offerings (up 2,500 percent) common stoclc public offerings (up 
1,000 percent) and stock market trading (up 1,000-3,000 percent) 
(as well as greatly increased merger and acquisition activity which 
is not shown on the charts). 

The statistics from the Administrative office actually overstates 
the true number of securities fraud class-action cases filed by a 
substantial amount. As you are aware, when the stock of a widely- 
owned public company collapses, there are frequently numerous 
class-action lawsuits filed — normally three or four and occasionally 
up to a dozen. Because a civil cover sheet designating in each of 
these individual actions as a securities fraud class action must be 
filed with each of the individual complaints, this results in the Ad- 
ministrative Office counting each of these identical cases as a sepa- 
rately filed class action even though in practice they are soon con- 
solidated into one case and prosecuted as such. We do not have any 
way of getting the actual numbers reflecting the consolidation proc- 
ess from the Administrative Office. However, according to Class Ac- 
tion Reports, the Administrative Office's figures are overstated by 
about one-third. Accepting this conservative assumption, the num- 
ber of securities fraud class actions being filed is less than 200 per 
year. This is obviously a small and manageable number and, in 
fact, an infinitesimal percentage of the approximately 225,000 new 
Federal filings made each year. 

Capital formation has not been adversely impacted by securities 
litigation. In fact, 1986-1991 has seen a "going public" boom which 
has raised billions in capital, created hundreds of millionaires and 
millions of new jobs. In light of these results, who can seriously 
maintain that the securities markets or securities professionals are 
being victimized by securities class actions? These actual results 
are totally inconsistent with any motion that abusive securities liti- 
gation is stifling the raising of capital or creation of new public 
companies. 

The Claims By Professionals Who Are Sued In Securities Class 
Actions Are Vastly Overstated 

Many of the largest suits against accounting firms in recent 
years were brought by the U.S. government arise out of the col- 
lapse of savings and loans. These were not class actions under the 
securities laws and these suits will not be affected in any way by 
legislation like H.R. 417. The accounting profession is trying to use 
the statistical and monetary impact of government suits against 
them for their role in the savings and loan scandals to get rid of 
suits by investors for securities fraud. This is disingenuous in the 
extreme. 
The AICPA itself just admitted: 

About 50 lawsuits alleging audit failures involving public com- 
panies are filed each year, and that number has remained rel- 
atively constant over the last 10 years. Unfortunately, we have 
seen some very significant incidents of fraud. . . . 

AICPA, "Questions and Answers — An Auditor's Responsibility to 
Detect Fraud," May, 1993. 

These suits have apparently not measurably affected the big ac- 
counting firms' profitability. Ernst & Young, one of the largest of 



276 

the Big Six firms, recently agreed to pay $400 million to settle 
suits by the United States arising out of the failure of many sav- 
ings and loans. After this settlement, Ernst & Young has assured 
the public that: 

75 percent will be covered by insurance. The balance will be 
paid by the firm in equal installments over the next four years. 
The annual settlement payments are about 1 percent of our reve- 
nues and well within our financial capability. . . . We are very 
confident of the firm's ability to handle the settlement terms. 
Ernst & Young will now move forward as a financially strong 
and secure organization. . . . 

Letter of Charles B. Eldridge of Ernst & Young, November 24, 
1992. 

These suits have also not affected the ability of accountants to 
obtain malpractice insurance. According to the Singer Insurance 
Group of New Jersey, which insures over 100 accounting firms in 
the New York City area, at least nine insurance companies are — 

"bidding against each other to try to secure as much [account- 
ing firm insurance] business on the books as they can during 
1993. We have seen premiums go down by as much as 50 percent 
in extreme cases. On the average, they are going down between 
20 percent and 30 percent." 

Letter of Al Singer, President, Singer Insurance Group, Inc., 
June 10, 1993. 

Q.2. Some of the criticisms of the current system may not be mutu- 
ally exclusive. Indeed, while critics of the current system argue 
that steps should be taken to curb litigation, others have argued 
that other steps should be taken to facilitate investor lawsuits, 
such as lengthening the statute of limitations for securities fraud. 
Are these two criticisms of the current system mutually exclu- 
sive? Or, should securities litigation reform and lengthening the 
statute of limitations be considered together? 

A.2. As I testified and responded above, the Federal courts are 
amply equipped to curb any abuses in the current system. As I also 
testified, there is a need to strengthen private rights of action 
under the Federal securities laws in a number of areas. These 
areas include: imposing treble damages in appropriate cases, pro- 
viding non-removable state court jurisdiction, increasing discovery 
sanctions for defendants, barring secrecy orders, modifying plead- 
ing requirements, and increasing the statute of limitations for secu- 
rities fraud. 

I do not believe the record supports the litigation "reform" pro- 
posals advocated by the accounting industry and others, particu- 
larly imposition of the English Rule and abrogation of joint and 
several liability. I share the views expressed by Federal and state 
law enforcement officials — the SEC and NASAA — at the June 17, 
1993 hearing that the straightforward issue of lengthening the 
statute of limitations should be considered separately and imme- 
diately by Congress and should not be held hostage (in NASAA's 
words) to a "whole host of unrelated and contentious litigation 're- 
form' issues." As the SEC stated flatly, "Extending the limitation 
period does not encourage frivolous actions." (Tr. at 97.) 



277 

A one-year period is simply not long enough for investors to dis- 
cover a complex fraud and investigate it and plead it with the par- 
ticularity required under Rule 9 of the Federal Rule of Civil Proce- 
dure, especially given the constant threat of sanctions under Rule 
11 for filing what is perceived to be a frivolous action. Also, the 
three-year absolute bar provision of the current statute of limita- 
tions is completely unsatisfactory, as it operates to bar claims 
where victims may be taken in by a long ongoing scheme — some- 
thing that frequently happens in municipal bond financings and 
the Tike — where monies raised from initial investors are used to 
pay interest during the construction phase of a project, thus lulling 
early investors into a false sense of complacency while the three- 
year absolute bar provision is running. 

The one-year from date of inquiry notice prong of the current 
Federal statute of limitations for § 10(b) claims can operate very un- 
fairly from the standpoint of investors. For instance, defendants 
will frequently claim that earlier disclosed information even if it 
did not in any way lay out that a fraud had occurred, nevertheless 
put investors on the inquiry notice and triggered the running of the 
short one-year period. This possibility has also contributed, I be- 
lieve, to what some perceive to be overly fast filing of securities 
fraud cases upon a dramatic revelation and sharp drop in the stock 
price. Since the defendants are free to point to earlier partial dis- 
closures as putting people on inquiry notice of fraud, it is impor- 
tant to file as quickly as possible after the ultimate dramatic rev- 
elation and stock drop to protect the plaintiffs against this argu- 
ment. 

In my opinion, a statute of limitations of three years from the 
date of inquiry notice and without any absolute bar provision 
would be the appropriate statute of limitations for § 10(b) claims. 
This type of statute of limitations, I believe, is most consistent with 
the intent of the Federal securities laws to protect investors from 
fraud. Prior to the Supreme Court's adoption of the uniform and 
shortened statute of limitations in its Lampf decision in cases 
pending in Federal courts located in California, courts looked to the 
California three-year inquiry notice statute and that worked fine 
for all concerned. I would urge a return to the three-year inquiry 
notice standard. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SASSER 
FROM GORDON K. BILLIPP 

Q.l. Critics charge that too many cases are pursued with a view 
toward extracting settlements from corporations and other parties, 
without regard to the merits of a case, and that the settlements 
yield large fees for plaintiffs lawyers but compensate investors for 
only a fraction of their losses. 

What do you think of these charges? Are there abuses in the cur- 
rent system? 

A.1. As a layman, I do not have sufficiant information to know 
whether or not these are "too many cases." I would assume that 
there are abuses in the current system. 

O.2. Some of the criticisms of the current system may not be mutu- 
ally exclusive. Indeed, while critics of the current system argue 



278 

that steps should be taken to curb litigation, others have argued 
that other steps should be taken to facilitate investor lawsuits, 
such as lengthening the statute of limitations for securities fraud. 
Are these two criticisms of the current system mutually exclu- 
sive? Or, should securities litigation reform and lengthening the 
statute of limitations be considered together? 

AJ2. Consider, and act upon, the two criticisms separately. Perhaps 
reform is needed to curb excesses. But, absolutely the statute of 
limitations should be extended! 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SASSER 
FROM RUSSELL E. RAMSER, JR. 

Q.i. Critics charge that too many cases are pursued with a view 
toward extracting settlements from corporations and other parties, 
without regard to the merits of a case, and that the settlements 
yield large fees for plaintiffs lawyers but compensate investors for 
only a fraction of their losses. 

What do you think of these charges? Are there abuses in the cur- 
rent system? 

A.1. 1 think these charges may be true and I am satisfied there are 
abuses in the current system. However, I think these abuses would 
be minimized if the investors had a written agreement with their 
lawyers as to how any compensation or costs would be divided be- 
tween them. 

OJ2. Some of the criticisms of the current system may not be mutu- 
ally exclusive. Indeed, while critics of the current system argue 
that steps should be taken to curb litigation, others nave argued 
that other steps should be taken to facilitate investor lawsuits, 
such as lengthening the statute of limitations for securities fraud. 
Are these two criticisms of the current system mutually exclu- 
sive? Or, should securities litigation reform and lengthening the 
statute of limitations be considered together? 

AJ2. I do not feel these criticisms of the current system are mutu- 
ally exclusive. In my opinion many cases of financial fraud are not 
being adequately prosecuted. By lengthening the statute of limita- 
tions, investors would benefit from having a longer period of time 
to develop the merits of their case if such merits really exist. 



PRIVATE LITIGATION UNDER FEDERAL 
SECURITIES LAWS 



WEDNESDAY, JULY 21, 1993 

U.S. Senate, 
Committee on Banking, Housing, and Urban Affairs, 

Subcommittee on Securities, 

Washington, DC. 

The subcommittee met at 10:10 a.m., in room 538 of the Dirksen 
Senate Office Building, Senator Christopher J. Dodd presiding. 

OPENING STATEMENT OF SENATOR CHRISTOPHER J. DODD 

The committee will come to order for the purpose of holding a 
hearing this morning on litigation reform. 

Let me first of all welcome everyone again to our second hearing 
on private securities litigation. And I want to give a special wel- 
come to our colleagues who'll be coming from the House, Congress- 
man Tauzin and Ron Wyden, who've been very involved in this 
issue for many, many vears. 

I also want to thank our other witnesses who've taken the time 
to be here this morning and prepare extensive testimony. 

At our first hearing last month, I outlined what we hope to 
achieve in these hearings. We have the strongest, fairest securities 
market in the world. Investors all over the world want to partici- 
pate in our markets because they are fair. Investors have remedies 
when they are treated unfairly, or when they are victims of fraud. 
That's significant. 

There is an important role for private securities litigation. I be- 
lieve that very strongly. And I think everyone of us on mis commit- 
tee support that role. 

Our purpose in these hearings is to determine whether the cur- 
rent system operates in the way that it should. Is it fair to share- 
holders? Does it promote the capital formation that is so important 
to economic growth and job creation in this country? 

At the last hearing, the subcommittee considered charges that 
there'd been a litigation "explosion," in targeting high technology 
companies in particular. 

We heard from corporate chief executives who said plaintiffs' 
lawyers target their companies when their stock drops below a cer- 
tain percentage, simply to extract settlements. We heard from a 
shareholder who told us she'd recovered only a fraction of her 
losses, while a large plaintiffs law firm won huge attorneys' fees. 
But when we heard from the plaintiffs lawyers and from otner wit- 
nesses, these allegations were disputed. 

(279) 



280 

We then turned to academic and other experts who had done 
studies on top of studies on securities litigation, and we found that 
even they disagreed as to the facts. 

Consequently, after a long hearing that lasted well into the after- 
noon, we found no agreement on whether there is in fact a prob- 
lem, the extent of the problem, or the solution to the problem. In 
my experience with this subcommittee, I've never encountered an 
issue where there is such disagreement over the basic facts. We 
often argue about policy, we argue about ideology, we often argue 
about politics, but it is rare that we spend so much time arguing 
about basic facts. 

It has now been over 5 weeks since our first hearing, and we con- 
tinue to receive letters and reports from the witnesses of the first 
hearing, each one taking issue with the statements made by the 
others. 

Today, we will try again. Based on my reading of the testimony 
last night, I do not Delieve we will find our distinguished witnesses 
today in any more agreement, quite frankly, than our witnesses 
were at the first hearing. But I hope that through this process, we 
at the committee at least can reach some conclusions about wheth- 
er the current system of private litigation is serving the public in- 
terest. 

Today, we'll focus more closely on the way in which securities 
litigation affects the financial disclosure system. How legitimate 
are concerns that the threat of litigation is hurting the disclosure 
information? 

We're also going to look at the important role of accountants, un- 
derwriters, and others. These professionals play an essential role in 
maintaining the integrity of the financial reporting system. 

But accountants, in particular, argue that the burden of private 
litigation falls far too heavily on them. They say they automatically 
are joined as defendants in securities fraud suits because of their 
deep pockets, and that they may be held liable for a disproportion- 
ate share of actual losses. They may be right. They argue that our 
legal system is making them, in effect, guarantors and holding 
them liable for the mistakes of others. And I'm concerned they may 
be right on that point as well. 

Other witnesses, as you know are here, will argue that the threat 
of private litigation is absolutely essential to give professionals an 
incentive to do their job and to win compensation for investors 
when those professionals fail to carry out their responsibilities. 

They criticize the accounting profession and say that it has failed 
to live up to its role as a public watch dog. These critics point to 
financial frauds that have occurred in which investors have lost 
millions or even billions of dollars. They argue that we should not 
lose sight of the important role that private litigation can perform 
in helping investors to recover losses caused by real fraud. 

Along with our distinguished witnesses from the accounting pro- 
fession, from the securities industry, from the bar, and from aca- 
demia, we're going to hear from consumer and shareholder rep- 
resentatives, as well. 

Protecting investors from fraud is the cornerstone of securities 
laws, whether the investor is a small shareholder or a pension fund 
manager. I look forward to hearing their views in particular. 



281 

Let me again thank our witnesses for coming here this morning 
and participating in this second hearing. I see that our colleague, 
Congressman Wyden, has arrived. 

Ron, let me ask my colleagues that are here for just any opening 
statements they have. 

Mr. Chairman, do you have one? 

OPENING STATEMENT OF SENATOR DONALD W. RIEGLE, JR. 

Senator Riegle. Thank you very much, Senator Dodd. And I 
know we have other Members too that have opening statements. 
But I want to commend you for scheduling this second hearing on 
the private securities litigation system. 

I think it's clear to all observers that vibrant securities markets 
are absolutely crucial to our economic growth. Businesses have got 
to have access to the capital they need to fund research and devel- 
opment, to expand operations, and certainly create and maintain 
the job base in America. 

And we are fortunate in our country that our securities markets 
are the most liquid in the world. Indeed, initial public offerings of 
stock this year, in the first 6 months, have proceeded at a record 
pace, and that's a good sign. 

Now some suggest that the efficiency of our capital raising sys- 
tem is being undermined by growing private securities litigation. 
They argue that such cases, many of them baseless, are often set- 
tled without regard to the merits. To the extent this is true, the 
system is imposing a "litigation tax" on capital formation that 
hinders our competitiveness and our future growth. 

We must not forget, however, that the strength of our capital 
markets rests in large part on the faith that investors can have as 
they seek redress in cases of fraud. 

The SEC's Director of Enforcement testified before this sub- 
committee just a few weeks ago. And I quote: 

The implied private right of action under section 10(b) and rule 10(bX5) there- 
under is critically important to the effective operation of the Federal securities laws. 

He cautioned the subcommittee that changes to joint and several 
liability or aiding and abetting standards, quote again: 

Go far beyond other measures that would affect only baseless claims. 

I think the subcommittee, and in a sense the full committee, is 
very fortunate today in having such a distinguished panel of wit- 
nesses, including representatives of the accounting and legal pro- 
fessions, the securities industry, important consumer groups, and 
the investment community to discuss these issues. 

And we have, as well, our House colleagues, Congressman Tau- 
zin and Congressman Wyden, here to describe legislation that 
they've introduced in this area. 

I want to especially welcome our House colleagues over to the 
Senate side today, and we're pleased that you're here to testify, and 
we always welcome your views and your input. We feel very strong- 
ly here in this committee about working together with the House, 
and also on a bipartisan basis, to try to work our way through 
these issues. 

I also want to especially welcome my good friend, Bob Bowman, 
who is testifying later this morning on behalf of the Financial Ex- 
ecutives Institute. Bob currently serves as the Executive Vice 



282 

President and Chief Financial Officer of the ITT Corporation, and 
prior to that, distinguished himself during 8 years as Treasurer of 
the State of Michigan in a most impressive way. 

And so I want to thank all the witnesses for their participation. 
I've got to attend to some matters in the Finance Committee this 
morning, but I will stay as long as I can. 

Thank you. 

Senator Dodd. Thank you very much, Mr. Chairman. 

Senator D'Amato. 

OPENING COMMENTS OF SENATOR ALFONSE M D'AMATO 

Senator D'Amato. Mr. Chairman, my statement would be super- 
fluous, given the manner in which you have introduced this subject 
to the committee. I'm interested in listening to our two Congress- 
men testify before I, too, have to leave. 

You have set it forth well. But certainly there's something that 
has to be done as it relates to litigation that is hurting the eco- 
nomic climate and is deleterious to capital formation. 

So I'm most interested in seeing what we can do, and under your 
leadership, and that of my distinguished colleague from New Mex- 
ico, Senator Domenici, I hope that we can come up with the kind 
of proposals that will make some sense, protect consumers, but by 
the same token, spare us from unneeded litigation that is costly to 
our system. 

Senator Dodd. Senator Domenici. 

OPENING STATEMENT OF SENATOR PETE V. DOMENICI 

Senator Domenici. Mr. Chairman, I think you know that I have, 
on this issue, a propensity to talk a lot. 

[Laughter.] 

But I assure you, I won't. You have put things in perspective, al- 
though I frankly believe, by the time this hearing's over with, a 
number of the facts that you've discussed as being equal on each 
side will probably tend to move one way or the other. Nonetheless, 
I must tell you what I think this is all about and what I think the 
reason for us being here is. 

First of all, I don't think there should be any doubt that this 
hearing is about the investors. This hearing is not about high-tech 
companies or others; it's how do we best protect those who invest 
in risk-taking companies and other equities in the United States in 
this great equity market. 

I've come to the conclusion, with nothing pejorative about partici- 
pants, that the judicial system and juries should be the last resort 
in protecting investors in a regulatory manner. Litigation is the 
most inefficient way to regulate that we could ever imagine. And 
I believe we are seeing litigation's inefficiency pervade the Amer- 
ican scene. 

We only have a little piece of it here. It is pervasive in many 
other areas, where we ask juries and trial lawyers to determine 
complex issues. In so doing, we clearly create absolutely unpredict- 
able situations that are not necessarily based upon reality. And, as 
a consequence, cases are settled for millions of dollars even though 
there are no merits to them. 



283 

Indeed, I believe good cases and bad cases are settled, and I 
think a real in-depth analysis would say there isn't much difference 
in the settlements, because a company ends up deciding that they 
can't gamble on a jury in this kind of complicated issue, and they 
settle. 

Equally as bad, there is now a threshold of insurance among 
them so that those who really do something wrong don't pay any- 
way because it all settles within the insurance limits. We end up 
spreading out, among equity companies and at the expense of in- 
vestors, we spread out this growing cost of insurance and the 
threat of litigation. 

And what does it enure to? I mean, there are some telling us it 
makes the securities industry and the investor more secure. But 
what we've already heard is that it's pennies for real victims and 
not much more for phantom victims, but millions for lawyers, re- 
gardless of the merits. 

Now, in the process, people are affected. So, indeed, harassing 
high-tech companies and their CEO's and their boards is the order 
of the day. Whether it's real or perceived, the threat of securities 
class-action litigation is a big factor of what you do or don't do, as 
a corporate executive. In most instances, we are forcing manage- 
ment to do things that doesn't end up benefiting anyone. 

Let me suggest that if you are a new risk company, risk has 
taken on the equivalence of fraud. So that if you're in a risk, high 
risk company, which we like in America, things don't go well all 
the time and your stock is volatile. Well, let the stock price dip 
once. And that risk company's sued and the settlement is there 
around, somewhere around $12-$25 million, and one could even 
graph what happened. 

A couple of companies said, let's get macho and defend these 
cases. And a couple of them in a row defended them, and the jury 
gave somebody $125 million. So there are many who think that's 
really what the case was worth. I doubt that very, very much. 
That's really what it's worth under today's system. The con- 
sequence is that the word's out; settle. The word's out; settle, and 
the class-action lawyers love it. 

In addition, let me suggest that we should have our companies 
disclosing more, rather than less. They should be disclosing more 
than the law requires, not less, and they should be disclosing it 
punctually, when they know it, even though they don't have to. 

There is now a chilling effect on the amount of information that 
companies volunteer because to volunteer good information is to in- 
vite a lawsuit if it doesn't pan out. 

So I've come to the conclusion, and I think this is a fair analogy, 
if the trends continue, this committee could be talking about its 
own version of don't-ask-don't-tell-just-sue. 

[Laughter.] 

Senator Dodd. How did we get into that subject? 

[Laughter.] 

I thought I'd avoid that here this morning. 

Senator Domenici. All right. Anyway, it'll be up some more. 

The accountants face a different situation, Mr. Chairman. We 
have the accountants of America moving in the right direction in 



284 

terms of assuming more serious responsibility as the auditor and 
watch dog. 

The one question we really have to ask, if we're going to expect 
accountants to be more proactive, and they've adopted some new 
proactive rules and some new guidelines and some new ethics, then 
should we give them a fair playing field, or should we continue to 
make them totally liable, rather than proportionately liable, when 
something goes amiss. 

If there are twenty people that have done things wrong, includ- 
ing a CEO, including a treasurer of a company, and a CPA, if we're 
going to ask them to completely change their approach to their fi- 
duciary relationship to their ethics, should we not seriously con- 
sider proportionate liability? I think the time has come to do that. 

Thank you very much. 

Senator Dodd. Senator Bennett. 

OPENING STATEMENT OF SENATOR ROBERT F. BENNETT 

Senator Bennett. Thank you, Mr. Chairman. 

I recognize I'm not a Member of the subcommittee, but I appre- 
ciate your tolerance in letting me participate in this because it is 
a matter of great concern and will surface before the full commit- 
tee. 

The only comment that I would make, picking up on what Sen- 
ator Domenici has said, is that we are indeed concerned about the 
investor. Very often in the testimony that we've been given, and as 
I looked through the prepared statements and some of the testi- 
mony that we will be given, the assumption is made that there is 
a difference between the investor and the corporation. 

Someone says the corporation must be punished for having done 
something wrong that makes the investor have less information 
than the investor needs. In the name of getting information for the 
investor, the company is damaged by class-action lawsuits. And 
who gets hurt. The investor. We should understand that there is 
no difference between the company and the investor. 

When we're trying to protect the widow and the orphan who has 
put her money into a corporation in the hope that it will provide 
for her old age — to put the most inflammatory face on it that we 
can — it's the widow and the orphan who own the stock that get 
hurt when the stock drops because of frivolous class-action suits. 

So I would hope we would keep that in mind as we beat our 
breasts and thunder about our love for the investor, and to protect 
the investor against the terrible company. It's the investor that 
gets hurt when the company has to pay out exorbitant settlement 
fees and legal fees that aren't justified in terms of actual practice 
and behavior. 

And with that, Mr. Chairman, I will join you in listening to the 
witnesses. 

Senator Dodd. Thank you very much, Senator Bennett. 

We welcome our two colleagues from the House, and your state- 
ments and supporting documentation that you may have with you 
will be included in the record. I'll apply that to all of our witnesses 
today and just say it once, so that it doesn't have to be repeated. 

I'm going to put the clock on here. Again, when I say it to every- 
body, I don't expect you to live with it rigidly, but just to give you 



285 

a signal as to where we are, so we can keep the process moving. 
Those lights will go off, the yellow and red lights, at about 5, 6 
minutes. Try to get to a point where you're sort of wrapping up, 
and that way we can keep the process going. 

We've got a pretty extensive list of witnesses here, and want to 
get to the questions. 

Billy, we are pleased to have you with us here this morning, and 
I know you've been involved in this issue for some time, as Ron 
has. And so we're happy to receive your testimony. 

You ought to pull that microphone up very closely to you. 

STATEMENT OF U.S. REPRESENTATIVE W.J. "BILLY* TAUZIN 
FROM THE STATE OF LOUISIANA 

Representative Tauzin. Senator, thank you very much. 

Ron and I are pleased to join you in this exercise of, we hope, 
learning more about this problem and perhaps learning about how 
we can solve it. 

I came today for those two reasons; one, to join you in recogniz- 
ing that there really is a problem when these lawsuits amount to 
bounty payments and blackmail-almost settlements in a litigation 
system that was really designed to identify fraud and redress 
wrongs committed by people who were knowingly and fraudulently 
misusing the system, then something's wrong. 

And when settlements are routinely made because parties know 
that they simply cannot afford to do what we ought to be able to 
do in court, and that is answer charges and allegations and correct 
misstatements of fact, the cost of doing that is so high that it's 
easier to pay off the attorneys and the claimants in the class-action 
suit, just to stop the allegations, just to stop the assassination of 
the reputation of the individuals involved in the company, then 
something has gone wrong. 

I have not come to tell you that we ought to, in any way, harm 
the system by which fraud and error that is committed knowingly, 
negligently, to harm stockholders and investors in companies ought 
to be abolished. 

On the contrary, we ought to make it a better system. We ought 
to do as Senator Domenici said; make sure that real fraud is de- 
tected and that persons are punished in a way, in a financial way 
that it means something to them. The cost is not spread on every- 
body in this sort of bounty/blackmail payment system that's devel- 
oped in our country. 

I didn't just come to tell you something's wrong, however. I also 
came, I hope, to give you some ideas about how we have suggested 
we can improve the law and make it work better for investors, for 
companies, and for all who are involved in this process. And as I 
searched for a way in which to make our case about what is wrong 
with the system, I think something that happened in this room a 
month ago probably made the case for me. 

A month ago, you invited some corporate execs to come and tell 
you about their experience with this law, to come and tell you how, 
within hours of something going wrong with their stock, some dra- 
matic shift in the stock prices, they found themselves in court. 
Within hours, a lawsuit was filed, claiming that they had fraudu- 



286 

lently done something to cause not only the stock to go down, but 
to misappropriate money as an insider trader, perhaps. 

They came forward to tell you about their experience with it, and 
how it affects their ability to be productive agents for an economy 
that needs some productive agents in it. 

They flew in, I think, from California for the most part, to be 
with you, from the high-tech region of the country where jobs are 
still being created. And they came to tell you about how America 
used to work, like Mr. Smith going to Washington, and how they 
wish it worked again, and how this litigation system is preventing 
it from working the way it used to work, and the way it could 
work. Then they got on a plane and flew home. And on their way 
home, one of the trial lawyers who practices in this field, took the 
stand here, and he began to do what trial lawyers do in these kinds 
of cases. He practiced triple A; allege, accuse character, assassinate 
if necessary, and then leave it to you and everybody else who heard 
these charges to try to fight your way through to find the truth. 

It didn't matter whether the charges were true or not. Just laid 
them out for you, while these gentlemen were on their way to Cali- 
fornia, and left it to us to find out over the last month just how 
factual those allegations were. Well, we did some research. We 
checked into it. I've got a chart up here, a little show-and-tell, that 
perhaps I think makes the case. 

I'm going to run you through a couple of Mr. Lerach's allegations 
the other day on these three chairmen, as they were on their way 
to California. He alleged, for example, that EMC Corporation chair- 
man, Richard Egan, sold stock just before the stock value fell. I 
checked the facts. The facts are that the suit in that case was 
thrown out of court because — these are the court's words — the sales 
began well before the deterioration of EMC's prospects. The court 
called that complaint "dead on arrival." 

But the counsel came to this chamber and led you to believe that 
this was some awful insider trader, this chairman of this corpora- 
tion, who ought to be punished somehow. And left that allegation 
sitting here for someone to try to correct it. I've tried to correct it 
today. 

He also alleged, in his appearance here, that the chairman of 
Adaptec, John Adler, was sued because he sold stock shortly before 
the share price collapsed, alleging an enormous fortune was made 
in the process. 

Here's the facts about Adaptec and the suit. The stock sale took 
place 9 months before the price declined, and Mr. Adler actually 
bought more stock 1 month before the decline in the price. And all 
of the transactions were on record, as they all are on record with 
the SEC for all to see, including the counsel who made this horrible 
charge, this horrible character assassination allegation before this 
committee as the gentleman was flying back to California after 
having done his civic duty in coming to try to tell you what's wrong 
with this system. 

Another case in point. Mr. Lerach mentioned about the suit 
brought against Silicon Graphics. In that suit, where Mr. Lerach 
talks about it being a case that was not in fact a frivolous case, 
these are the judge's words: 



287 

The class actions seem to be falling into disfavor these days, and this case 
is one example why. The likely outcome was a settlement, and the only winners 
would be the attorneys. 

There was a lady who testified. Mr. Lerach didn't miss her ei- 
ther. He talked about her failure to disclose to you her relationship 
in securities firms. Check the record, gentlemen. Check her state- 
ment. 

She disclosed, up front, that she worked for a stockbroker firm. 
And yet the allegation was made that she somehow came over here 
and failed to disclose to you, her relationship to stockbrokering. 

I make these points to you, and there are others on the board, 
just to make the case: It's so easy to allege, to accuse, to character 
assassinate companies, individuals, people who work with compa- 
nies and individuals who make public stock offerings, and then 
leave it to them to pay all the expenses of discovery by which you 
have to disprove these negative statements. 

Now, gentlemen, I'm not going to tell you that some stock compa- 
nies are not headed by corporate execs who are proud of their com- 
panies, and who may, from time to time, make very optimistic 
statements about the job they're doing and the job their company's 
going to do. But that's a far cry from fraudulently luring people 
into investing into that company. There ought to be a difference in 
the law. 

If I have but a few minutes, Chris, I'd like to run through what 
we have proposed on the House side, as a very, one-two-three-four- 
step process where we could cure some of this, where we could help 
make this a better system, where investors would be protected, and 
companies would be spared some of this awful allege-accuse-assas- 
sinate system where they have to pay people off just to make them 
go away. Here's what we suggest. 

First of all, why not make a correlation between responsibility 
and blame by establishing proportionate liability? 

Under the rule, we would put into the law and in our bill, the 
decision whether to sue a party would turn on the merits of the 
claim, not on the needs for additional sources of financing the 
claim. 

This business of suing everybody in a shotgun approach, every- 
body who touched the securities firm, in the hopes that they'll chip 
in something in the settlement, that the insurance will be enough 
to make a good settlement pile, ought to come to an end. 

We ought to attach blame where it really lies, and if someone 
committed fraud, go after them. 

Second, the bill gives the plaintiffs and attorneys an incentive to 
file only those cases in which the claim appears to have merit by 
providing the option to the judge of requiring the losing plaintiff to 
pay the defendant's legal costs. Just makes it a little more careful. 

Maybe the suit's not going to be filed within the first 3 hours. 
Maybe the plaintiffs counsel will actually investigate a little bit to 
see whether or not real fraud has been committed, or there simply 
has been a vacillation of volatility in the stock. 

Third, the bill distinguishes between honest mistakes and fraud. 
We ought to do that in law. We ought to make a distinction be- 
tween people who are going around honestly conducting their busi- 
ness and making mistakes, and those who lmowingly, purposely de- 



288 

fraud people in our society. The current law makes no such distinc- 
tion. 

We would make such a distinction by requiring a higher stand- 
ard of proof, clear and convincing evidence that the defendant in- 
tended to commit securities fraud, when the case is brought. 

And finally, we would attack a clear series of abuses in the litiga- 
tion system. One, we would bar the payment of bounties. The idea 
of paying people for bringing them lawsuits ought to end in Amer- 
ica. And second, we would prohibit attorneys from acting as counsel 
in cases in which they have a financial interest. That ought to be 
pretty common sensical reform. 

Gentlemen, we don't have to rewrite securities litigation law. We 
don't have to throw, as some people say, the baby out with the bath 
water. We've got a good set of laws. We need to improve them. We 
suggest to you working with us to improve them. We suggest end- 
ing the allege-accuse-assassinate system. 

If you join me in this effort, let me warn you, it just may happen 
to you too. The first thing that happened when we filed the bill, 
the allege-accuse-assassination started. 

The accountants want to see this bill passed. They support those 
of us who agree with them. And we get support from these people 
in the political process, as you get support from folks who agree 
with you in your campaigns. 

The first thing that happened was, accuse-and-assassinate. Those 
then supported by the accountants so it must be a terrible bill, 
must be something wrong here. It's the same old game. You join 
me in an attempt to improve this law, you may be subjected to it, 
too. 

But I ask you to think seriously. We've got to take this kind of 
risk, make some improvements in the law. We're not just here just 
to be here. We ought to make a difference. We ought to make the 
laws better for America. And here's a chance to do it, gentlemen. 

Thank you. 

Senator Dodd. Thank you very much. 

Congressman Wyden. 

STATEMENT OF U.S. REPRESENTATIVE RON WYDEN FROM 

THE STATE OF OREGON 

Representative Wyden. Mr. Chairman, thank you. I very much 
appreciate the chance to be with you, and certainly agree with 
much of what I have heard all the Members saying, and my friend, 
Congressman Tauzin. 

I first want to commend you for even holding these hearings. As 
someone who has sat through more than twenty hearings on the 
accounting profession over on the House side, I can tell you one of 
my constituents described it as having something akin to the sex 
appeal of prolonged root canal work. 

These are extraordinarily complicated and arcane issues, and I 
appreciate your tackling them. 

I think, Mr. Chairman, you and Senator Domenici both said 
something that I think defines the kind of bipartisan challenge 
that we've got here. You said, Mr. Chairman, that there are great 
disagreements on the question of legal reform, and that is certainly 
the case. 



289 

I happen to be for it. I have voted for product liability reform leg- 
islation in the House, along with Congressman Tauzin, when we 
did it in the Commerce Committee. You're absolutely right; there 
are enormous differences of opinion. 

Senator Domenici, to his credit is absolutely right in saying that 
the securities laws are primarily there to help the investors. And 
that's what this is all about. Beyond our sympathies for high-tech 
companies, and I have them in great numbers in Oregon, the secu- 
rities laws are primarily to help investors. 

So I would hope that, as the debate goes forward about legal re- 
form, we could address one issue that has been the product of 7 
years, 7 years worth of public discussion, more than twenty hear- 
ings, more than 100 hours of formal testimony on what I think is 
the public interest foundation which can, in effect, lay the predicate 
for moving on to discussions about legal reform. 

That public interest foundation, in my view, is more aggressive 
efforts by auditors to look for fraud, and when they find it, to re- 
port it promptly to Government regulators. 

I think all of you and our colleagues know that, again and again, 
what we found during the 1980's was, shortly after a clean audit 
was issued, we would have a major public corporation go belly up. 
We would see this in financial services, we would see it in defense, 
we would see it in health care, we would see it in environment. 
Again and again we would see, right after a clean audit, a corpora- 
tion would go belly up. 

It prompted the Washington Post, in an editorial last year, to ask 
"Where were the auditors? ' 

Now, what I cr,n tell you is we know that they were not about 
the task the U.S. Supreme Court set out for them in the Arthur 
Young case in 1984, which was to recognize that their responsibil- 
ities, first and foremost, as Senator Domenici talked about, ran to 
the investors and the public, and not to the client. 

So what we have tried to do in the House is to fashion a biparti- 
san bill to bring about more aggressive efforts to find fraud and re- 
port it. It has passed the House now with bipartisan support, and 
I'm very hopeful that we can get this enacted in this Congress now 
when there is agreement. 

The auditors, to their credit, have come around to supporting us. 
They have worked closely and cooperatively with us. The Securities 
and Exchange Commission supports this. The Public Oversight 
Board supports it. And we have to have it because the internal 
changes which, as Senator Domenici points out, are clearly a step 
in the right direction, don't go far enough. 

We formally have to change the process when an auditor resigns. 
What happens right now, it's known as the 8K process, the auditor 
is supposed to indicate why they resign, thereby giving an oppor- 
tunity for regulators to follow up. 

Unfortunately, the 8K process is still a system that allows, in a 
great many instances, auditors to give evasive statements that list 
virtually every reason but the truth as to why an auditor resigns. 

So under our legislation, we would force a prompt disclosure of 
it. We would have a chance, for example, to deal with the kind of 
problem that we saw in Charlie Keating's American Continental 



290 

Corporation case, which is a perfect example of why the system 
doesn't work. 

In that filing, the company stated, and the auditor did not dis- 
agree, that the auditor was resigning but that there were no dis- 
agreements in any matter of accounting principles or practices. In 
fact, there was massive fraud and the accountants knew it, but the 
system did not require that there be prompt disclosure so that the 
Government could have intervened in a fashion that would have 
really protected the public and the investors. 

Our legislation that's passed the House would, for the first time, 
specifically require auditors to report publicly when a company is 
ripping off the investor and the public. 

Mr. Chairman, I see the red light is on. In the House, we get 5 
minutes, so we've had some practice on this. 

I very much appreciate your willingness to dig into these issues. 
We have come a long way on fraud reporting. This legislation has 
passed the House several times. It's finally gotten a consensus 
among professional groups. I think that the professional groups un- 
derstand that this legislation ought to pass as a floor of public pro- 
tection, so that there then can be discussions of how next to change 
the legal system. And I look forward to working with you and our 
colleagues on a bipartisan basis in both areas. 

Senator Dodd. Thank you very much, Ron, for your testimony. 

You and I have talked about this in the past, and I know how 
very hard you've worked over a long period of time on this. As you 
know, at the end of last session, there was a procedural problem 
we had that had nothing to do with the substance of the legisla- 
tion. 

Our hope is that it will be a part, either on its own or a part 
of something else in a larger context. But I know of no one who 
has any substantive disagreements with what you have fashioned 
and worked so hard on over the years. 

Let me just ask of both of you. You both have two pieces of legis- 
lation. Do you both support each others bills? 

Representative Tauzin. Yes, we do. 

Senator Dodd. Are you cosponsors of each others bills? 

Representative Tauzin. Well, let me not speak for Ron. I totally 
support the effort that Ron is making. And, as Ron has pointed out, 
not only is it a bipartisan effort, it's an effort in which those of us 
on the subcommittee and the full committee, Energy Commerce, 
worked collectively to produce. It's one in which we've worked hard 
to bring the professional groups in support. They have come com- 
pletely behind the measure. 

Senator Dodd. You're talking about Ron's bill. 

Representative Tauzin. I'm talking about Ron's bill. 

Senator Dodd. Right. 

Representative Tauzin. I will not speak as to Ron's support for 
the liability reform bill, other than to say that Ron and I have had 
many discussions, and Ron is interested in helping us examine this 
area, and see whether improvements can be made. 

Senator Dodd. Let me ask Ron. 

Representative Wyden. Mr. Chairman, I have voted for product 
liability reform in the House. I have in effect crossed the Rubicon 
and there is no question that our legal system needs reform. 



291 

I think you and all our colleagues know what a difficult task this 
is, in order to bring about reforms so we can help our companies, 
while at the same time, not hurting the innocent victims that Sen- 
ator Domenici and every other Member wants to protect, as well. 

I would submit to you that I believe that it is critical that we 
move ahead with fraud reporting first, in an area where we have 
consensus, where it is possible now, as a result of 7 years' worth 
of work of a lot of Members and bipartisan labor to have a consen- 
sus, pass that bill, lay the foundation of protecting the public inter- 
est, stopping these kinds of frauds and abuses that come from a 
system that doesn't require full disclosure. And after that bill is 
passed and signed into law, then begin the discussion of how to 
proceed on legal reform. 

I think it is the view of the profession that it is important to get 
fraud reporting out of the way. We can do that now. We have a 
consensus. 

As I said, I believe that legal reforms are needed. I voted for 
them. But I think it would be a great mistake to tie the two to- 
gether. My sense is, if you tie the two together, we hang ourselves 
up again for eons trying to address thoughtfully a legal reform bill. 

I would say on the basis of 7 years of toiling in the vineyards and 
recognizing, recognizing that Senator Domenici and Congressman 
Tauzin are absolutely right in saying that there's a very real prob- 
lem with respect to the legal system, I would ask that we move the 
fraud reporting first, assure the public that before we start talking 
about other issues, we're going to protect their interests first, and 
then go from there. 

Senator Dodd. But I noted you voted for product liability reform. 
So, given the opportunity, you'd vote for the Tauzin bill? 

Representative Wyden. Well, I think we're going to work 
through, in hearings, carefully how to address it. 

Senator Dodd. I'm going to nominate you for an ambassadorial 
post in a minute. 

[Laughter.] 

Representative Wyden. Well, having, having 

Representative Tauzin. Senator, if I can jump in here, let me tell 
you quickly, we're not wedded to every 

Senator Dodd. I understand. I think you made the point. 

Representative Tauzin. — and what we're literally going to try to 
do is negotiate a good reform package with you. 

Senator Dodd. I don't want to dwell, I don't want to dwell. 

Let me come back, Billy, to your bill. There are a couple of areas 
where I have some — and Senator Domenici knows this — I have just 
some fundamental problems. 

The English rule, for instance, I just think is a dreadful idea. I'll 
be very blunt with you. The idea that we will require the losing 
side to pay the attorneys' fees has such a negative impact on your 
moderately financed plaintiff that you just discourage people from 
coming forward entirely. 

I'm not suggesting there are not cases you'd like to have fee- 
shifting, but I just see an absolute rule as being a major blow to 
people who don't have the resources to come forward. You just beat 
them financially. 



292 

Representative Tauzin. Well, understand, Senator, we've not rec- 
ommended that the English rule be in effect, in every case a losing 
defendant pays costs. But we have suggested that there be some 
option to the judge to do that, where it is clear that one of these 
cases has been brought just to see if they can exact some sort of 
blackmail settlement. 

Senator Dodd. That's being done already. There is some discre- 
tion on the part of the judge. 

Representative Tauzin. The problem is that rule 11 is very rarely 
exercised. 

Senator Dodd. But it exists. It's there on the books. 

Representative Tauzin. Yes. But in fact, in one of the cases that 
Mr. Lerach talked about and that the chairmen of the companies 
talked about, there was a finding but there was no merit whatso- 
ever to the case, but the judge refused to use rule 11 in that case. 
I think we can strengthen that provision perhaps in this reform, 
without necessarily going to the English rule. 

Senator Domenici. Mr. Chairman. 

Senator Dodd. Let me just finish the last point, Pete, then I'll 
turn over the whole thing to you. 

Your bill also would raise the preponderance of the evidence 
standard to clear and convincing. Not even the SEC has to meet 
such a high standard in its enforcement cases, as you're suggesting 
with the reform here. Why would you apply a different standard 
in this situation than the SEC has to meet? 

Representative Tauzin. Because we're talking about fraud. It's 
simply too easy today to allege and to absolutely vilify not only the 
reputation of the individuals involved but the whole corporate 
structure and to damage the success of that company by alleging 
fraud. It's so easy to say that because some statements don't jibe 
with what really happened in the real world, that there was oDvi- 
ously an intent to defraud. And that is routinely done now. It 
seems to me we ought to have a higher standard of proving fraud 
than proving negligence. And we usually do in the law. 

Senator Dodd. OK. 

Representative Wyden. Mr. Chairman, can I just add a point on 
that? 

Senator Dodd. Yes. Then I'll turn to my colleague from New 
Mexico. 

Representative Wyden. You're having nominated me for an am- 
bassadorship is much appreciated, but I think your questions to my 
colleague, I mean, highlight the point. There are a number of areas 
in the Tauzin bill, that I think will get bipartisan support, that 
make sense. Streamline the system, don't hurt victims. 

There are other areas where we've got a lot more work to do. 
Let's work on those kinds of areas while at the same time going 
forward with something where there's a consensus that helps the 
public. 

Senator Dodd. Let me just ask you, Ron, quickly. And, again, I 
want to express my admiration for what you've done with your bill. 
Your obviously trying to get people to come forward to detect fraud. 

There have got to be some steps that you think need to be taken 
by issuers and accountants, or regulators, for that matter, to better 
ensure that fraud is kept out of the securities market to begin 



293 

with, so it's not just a question of detecting it and then reporting 
it, but how do you stop it from occurring. 

Your bill deals with getting it reported. And I don't disagree with 
that. But are there some steps in your mind that could be taken 
to discourage it from ever occurring in the first place? 

Representative Wyden. First let me emphasize, Mr. Chairman, 
that we don't want this bill to ever kick in. I mean, what we're try- 
ing to do is set up a preventive system. 

But I think when you pass the fraud reporting legislation, you 
are sending a message to every corporate board room in America. 
You are telling every corporate board room, every manager in that 
board room that, for the first time, the auditors' responsibilities are 
clearly going to be to the public and not to the company. 

It is amazing, there was a op ed piece written in the New York 
Times recently by a gentleman named Jay Barris, who is consid- 
ered one of the premier financial services lawyers in the country. 
This person was concerned because accountants weren't standing 
up for their clients. 

This is an individual, one of the premier authorities, and he was 
misrepresenting what the Supreme Court said the profession's all 
about. One of the premier authorities in the country didn't under- 
stand that the accountants' responsibility runs to the public. 

I think when you pass fraud reporting, you send a message to 
every corporate board room in America that things are different. 
That auditors' responsibilities are not primarily to the company, 
but to the public. And I think that's the real preventive benefit 
here that will keep these frauds from breaking out. 

Representative Tauzin. I concur in that view, Senator. I think 
it's correct. 

Senator Dodd. I don't think there's any debate here on that. 

Senator Domenici. 

Senator Domenici. Well, Mr. Chairman, you indicated your dis- 
like for the English rule. 

Frankly, I think the situation is so far out of hand, whereas 10 
years ago, I might have agreed with you, but I'm not so sure I 
agree with you now. Because I think one of the ways to put balance 
back in this is to send a message to the lawyers. He's trying to 
send a message to the accountants and auditors of America. 

You commented that you would not want to stifle lawsuits for 
those who are not financially able to bear the cost of bringing a law 
suit. It would be instructive for us to find out whether a class ac- 
tion in the securities area under the Federal Rules, has ever not 
gone forward because there wasn't enough money. The class-action 
plaintiffs' lawyers put up the money. It's all contingent fees. The 
lawyers hire the plaintiffs in these cases. That is part of the prob- 
lem. 

Do you think Pat Reilly, the lady who came here and told us that 
she was part of a class-action suit, and she got very little and was 
complaining about it, had to put up any money? She didn't tell us 
she had to put up a whole bunch of money for that lawsuit to go 
forward. Where did the money come from? Either of you have any 
idea where the money comes from for the filing of these suits? 

Don't the lawyers do all of the discovery on the case? If we win, 
we get paid a large proportion of the settlement fund? 



294 

I don't think you ought to worry too much about not being able 
to afford class-action litigation. It may be that lawyers won't be 
able to afford the frivolous, unmerited law suits they're filing, and 
I don't know that anybody should consider that as stifling the ap- 
propriate adjudication of issues. 

Nobody ever appointed the lawyers of America, in their capacity 
as lawyers, to be those who are supposed to prevent what's going 
on that's not right in the industry. 

Senator Dodd. Well, Pete, if you'll just yield for a second. If you 
change the law to say that and strengthen the requirement that 
judges award attorneys' fees to the losing side, you're going to have 
a very different reaction by the trial bar in these matters. They're 
no longer going to be doing it the way you suggest, but they're 
going to be looking for that money up front from their clients, 
which means they're going to have clients who are going to be un- 
willing to go forward. 

Senator Domenici. First, Mr. Chairman, I don't think that's 
what Representative Tauzin's bill says. It's optional. 

But we have prepared language heretofore. You've reviewed it 
and it's not whoever loses pays. But rather, you establish some 
more strenuous burden attached to that loss. It's not just losing a 
real factual case. We wouldn't change anything there. 

Representative Tauzin. Senator, if I may? In Financial Executive 
Journal, Mr. Lerach gave an interview that I commend to your at- 
tention about how these lawsuits are prepared and filed and proc- 
essed. 

In it, he states that today, there's a vast amount of information 
available on public companies that was simply not available a dec- 
ade ago. For instance, it's easier to obtain securities analysts' re- 
ports on a company, every press release issued by the company, all 
inside trading records. Today, you can obtain all the SEC 10K fil- 
ings immediately, on a disk. It's pretty simple now to get a lawsuit 
filed within hours of any volatility in the stock prices. And that's 
what occurred. 

Senator Dodd. We asked him that question. I think there's a 
good example where some reform is needed. Very honestly, he said 
the reason we do it is because you want to be the lead firm. And 
the first guy to file is the one that gets to be the lead firm. Now, 
there's ways I suspect we can change that so just because you file 
first doesn't mean you get all the action. 

Representative Tauzin. There may be some things we could do 
there. 

I only suggest to you that it's not very difficult for lawyers to get 
these cases filed; it's very cheap to file them. Information's already 
available from public filings for them to get enough allegations in 
the suit to get into court, and then it's up to the defendants to 
come up with all the money in the discovery process, pending the 
settlement, which usually is based upon how much it's going to cost 
us to go through discovery, how much can we pay them just to get 
them away from us. And that's not a good system. 

Senator Domenici. Don't they also have lists in their own offices 
of who owns stock in these various companies so that the lawyers 
can select their plaintiffs? 



295 

Representative Tauzin. Yes. That's all on disk too. So they can 
call around and get all their plaintiffs together in a hurry. 

It's a very simple process. They have gotten as high-tech as the 
companies they're suing, for Goa's sake. And they are as good at 
using computers as any high-tech firm in Silicon Valley. It's not a 
question of somehow we're going to change the law and keep them 
out of court. They're going to go to court. 

What we want to do, Senator, is ensure that when they make al- 
legations of fraud, when they character assassinate not only the 
companies but all these individuals that serve as board members 
and officers of corporations, people who dare to work for them as 
accountants, financial advisors, or analysts, and allege that these 
people are fraudulent, that they're somewhat devious characters in 
our economic system, that thev come with a little more than just 
an allegation or charge that nooody can answer. 

Senator Dodd. Well, Billy, Fm sympathetic to some changes 
here, but in fairness I should point out that under Federal law, 
when you allege fraud in these matters, you must allege it with 
particularity. That's the law. It says particularity. 

Representative Tauzin. Senator, look at the particularities up 
there. It's easy to allege lie. It's easy to say something. 

When I was going to law school, one of our professors once, al- 
ways quoted, it's a simple thing to accuse the Bishop of Boston of 
bastardy; it's a different thing to prove it. It's easy to allege it with 
particularity. 

But look at the facts here. Look at what they did to the chairmen 
of these boards of these companies on their way to California, and 
led you to believe they were such devious characters, when the 
facts are completely opposite. 

Senator Domenici. Why did you have to make that fellow Catho- 
lic? Couldn't you have said somebody else? 

[Laughter.] 

Representative Tauzin. You've got two. You've got the Chairman 
and another guy right here. 

Senator Domenici. Strike that from the record. 

[Laughter.] 

Representative Tauzin. In the Catholic Church, we follow a pol- 
icy to tell, even if you're not asked, you know how it goes. 

[Laughter.] 

Senator Dodd. All right, we're moving on here, I'll tell you. This 
may become the most popular hearing in Washington. 

Representative Wyden. Mr. Chairman, the Jewish kids would 
like no part of this. 

[Laughter.] 

Senator Dodd. Senator Bennett. 

Senator Bennett. Thank you, Mr. Chairman. 

I have the advantage or disadvantage, depending on one's point 
of view, of not having gone to law school. So I approach this from 
a slightly different perspective. I'm very sympathetic with the com- 
ments that the Congressman has made and the allegation versus 
fact chart that he's given, because I have seen this happen in the 
business community. 

I won't repeat the story that I repeated at our earlier hearing 
about my father's experience of lawsuits that were clear blackmail. 



296 

filed again and again, in a routine fashion, simply to obtain a set- 
tlement. And the individual riling them knew they were without 
foundation, and the company settling them knew they were with- 
out foundation. But both realized that the nuisance value was 
about $100,000 every year. The law firm would file it every year. 
The company would settle every year because the company realized 
that $100,000 a year was cheaper than the legal expenses of de- 
fending themselves appropriately. 

It sounds to me like what you're proposing, Congressman, would 
go a long way toward stopping that kind of nonsense. And I do not 
find any problem with saying that the judge now has the option to 
invoke the English rule, as opposed to some reform advocates who 
say the judge must give the losing side the bill. 

I think that's inappropriate. I agree with you that that would 
provide a chilling effect in many circumstances. But if someone 
knows that there's always the possibility that the judge could find 
his suit frivolous, that that would cause him to go in with a slightly 
higher threshold of proof than just the allegation threshold that ex- 
ists now. 

There's one other aspect of it with which I've had some personal 
experience that I'd like you to comment on briefly, and maybe it 
does not belong in this circumstance. But I think it is appropriate 
in the discussion. 

There are people who make their living short-selling stock, and 
have discovered that the allegation method of mouse trapping a 
company can cause the stock to drop, and thereby create short-sell- 
ing opportunities that they can take advantage of. 

Usually, they don't file suit with the lawyers. Usually, they find 
some columnist who is widely read who will repeat the rumor in 
his or her column, watch the stock drop, and then the short-seller 
cashes in on the drop in stock. And when the reality comes along 
weeks, months later, and the stock starts to recover, the short-sell- 
er has made the profit and moves on. 

Clearly, these strike suits, as they were called in the previous 
hearings, present tremendous opportunities for a short-seller. The 
net effect on a company who goes through one of these cir- 
cumstances is that management time is devoted to issues that have 
nothing to do with building the company. Lawyers get rich, which 
means that management resources are diverted away from things 
that would build the company, and the economy overall suffers. 

Now, somebody says, oh, it isn't that big, but I guess the chaos 
theorist who says, when the butterfly flaps his wings one place, it 
causes a hurricane someplace else, would say that this kind of ac- 
tivity does hurt the economy overall as it has its ripple effect. We 
see lower jobs, we see lower profits, and ultimately, from a Govern- 
ment point of view, we see lower tax revenue and bigger deficits. 

In your studies of this, and you two have spent more time look- 
ing at this than I have, do you see any indication that some people, 
in addition to the lawyers getting rich on these fees in these black- 
mail settlements, are using this kind of device to manipulate the 
markets and make short-sale profits by pushing things down 
through this kind of allegation? Or is that a chimera out of my in- 
experience? 



297 

Representative Tauzin. Senator, I'm sure that occurs, just as I'm 
sure that in political campaigns, there's a certain amount of value 
in your opponent saying bad things about you to bring your stock 
down. While we would certainly like to discourage both of those 
things from happening, I'm not sure we can make them illegal. 

What we ought not do is encourage, unnecessarily, the filing of 
those kinds of suits or encourage, in our own business, the practice 
of fraud and deceit in campaigning. It's the same kind of analogy. 
It seems to me that the more you permit the current system to 
exist without reforming it, the more you permit some people to feed 
off of it in that fashion, just as some, not the great majority of law 
firms in America, but some law firms are clearly feeding off of rule 
10(b)(5) cases. 

Just as some who will use that same process to feed on a market 
that would cause the stock to go down in the face of allegations, 
such as you had before this committee, I'm sure that occurs. I'm 
sure that there'll always be people willing to use whatever system 
we devise to protect against fraud, to actually commit fraud and 
sort of turn things on its head. Again, I'm not sure we can make 
it all illegal, but we doggone well ought to quit encouraging it. 

Senator Bennett. Thank you. 

Senator Dodd. Thank you very much, both of you, and I appre- 
ciate immensely your commitment to this issue. And we'll stay in 
touch with you on it, as we move forward here and try and craft 
some legislation. 

Clearly, we're going to deal with product liability this year. We 
almost did last year when we came within a vote or two of passing 
some major reforms in product liability. 

Senator Heinz and I go back almost 7 or 8 years ago, trying to 
get something done in that area with Guido Calibrezi, the Dean of 
Yale Law School, who has a deep interest in tort reform. I think 
there's an appetite here to want to do something in this area, and 
I think it's a question of what is the responsible way to move. So 
you've contributed significantly to that. 

Representative Tauzin. If I can make one final point, Senator? 

Senator Dodd. Yes. 

Representative Tauzin. We can wait for the major tort reform to 
occur in America. All we can do, as Mr. Wyden has suggested, we 
can move forward with good public interest legislation requiring 
better disclosure, more pressure on people to not in fact be careless 
or fraudulent in their statements or allegations about a company's 
potential success. We can do all those things, but we ought to, si- 
multaneously, at least give a fair playing field to the people who 
are going to accept that greater public responsibility. Give them 
some chance to avoid the awful horror of these lawsuits. 

Senator Dodd. And by the way, let me just say for the purpose 
of clarity that what you re suggesting is not the pure English rule. 

Representative Tauzin. That s right. 

Senator Dodd. People know generally what the English rule is. 

Representative Tauzin. Us Cajuns don't like the English rule 
much either. 

[Laughter.] 

Representative Tauzin. They kicked us out of Nova Scotia a long 
time ago, if you'll recall. 



298 

Senator Dodd. Let me just note, so people know, that page five 
of Congressman Tauzin's bill, says that if the court, in any implied 
private action arising under this act, enters a final judgment 
against a party on the basis of a motion to dismiss, motion for sum- 
mary judgment, trial on the merits, the court shall — and this is 
where it becomes mandatory — upon motion by the prevailing party, 
award the prevailing party reasonable fees and other expenses, un- 
less the court determines that the position of the losing party was 
substantially justified. 

My point here, as I would say to you, while it's not the English 
rule, it can still have the same effect. Obviously any good lawyer 
has to say to his clients, if we come through this and we lose, I'm 
coming back to you to pick up these fees. I'm not going to swallow 
them necessarily. And that's where I get a bit concerned about it. 
But it's not the English rule, per se. 

Representative Tauzin. Senator, we have a rule in Louisiana. 
That is, if you file a lawsuit and you try your case, and the judge 
refuses to render judgment, and a prolonged time passes, you can 
file a motion to have the judge's salary suspended until he renders 
judgment. 

Senator Dodd. That's Louisiana, though. 

[Laughter.] 

Representative Tauzin. But the point I'm making, Senator, is no- 
body ever uses that rule because it guarantees you the wrong kind 
of judgment. 

[Laughter.] 

Senator Dodd. C-SPAN is covering this live. I suspect there are 
going to be a few people who are going to try using that. 

Representative Tauzin. But the point is that there's some rules 
that just don't work. We think we can build a better rule here. 

Thank you. 

Senator Dodd. Thank you. Thank you both. 

We're now going to go to our second panel. Let me introduce 
them to you, and ask them to join us. 

Jake Netterville is chairman of the board of the AICPA, from 
Baton Rouge, LA. 

Let me just say, Russell Long and Senator Bennett Johnson 
called me and have spoken highly of you, Mr. Netterville, and we're 
pleased to have you here with us. 

Mr. Netterville. Thank you, Mr. Chairman. 

Senator Dodd. They wanted to let you know they have a high 
regard for you. 

Professor Abraham Briloff is professor emeritus of accounting at 
the Baruch College at the City University of New York. 

Mr. Robert Bowman is from the Financial Executives Institute in 
New York. While he may have been a public official of Michigan- 
Senator Riegle has already made reference to him — he's now a resi- 
dent of Connecticut. And we're pleased to have Mr. Bowman with 
us. 

Maryellen Andersen is with the Council of Institutional Investors 
from Hartford, Connecticut. We're pleased that she's here. 

Mr. A. A. Sommer, Jr., is the chairman of the Public Oversight 
Board of the AICPA in Washington. 



299 

Melvyn Weiss is a partner of Milberg, Weiss, Bershad, Hynes 
and Lerach. His partner, Bill Lerach, was here last week. We're 
pleased to have Mr. Weiss with us this week. 

Marc Lackritz is president of the Securities Industry Association. 

Ralph Whitworth is the president of the United Shareholders As- 
sociation. Mr. Whitworth and I had the chance to meet yesterday 
coincidentally in the corridors of the Congress. 

Mr. Ralph Nader is with Public Citizen and no stranger to the 
committee process here or to most people in this country on issues 
of public concern and consumer interest, and he's a Connecticut 
resident, I might add. We're loading up with the nutmeg State here 
this morning. 

We welcome all of you. 

I apologize in sort of crowding you in here, but it seemed to be 
the best way to proceed, so we can get some dialog going between 
you. 

I'm going to ask you to try and keep your remarks down to that 
time of 5 minutes or so, so we can get through your testimony as 
quickly as possible, and then get to the questions. 

Mr. Netterville, we'll begin with you. And again, thanks for being 
here, and keep your eye on that clock. 

STATEMENT OF JAKE L. NETTERVILLE, CHAIRMAN OF THE 
BOARD, AMERICAN INSTITUTE OF CERTIFIED PUBLIC AC- 
COUNTANTS, BATON ROUGE, LA; ACCOMPANIED BY: MARK 
GITTENSTEIN, SPECIAL COUNSEL TO AICPA AND FORMER 
CHIEF COUNSEL, SENATE JUDICIARY COMMITTEE 

Mr. Netterville. Thank you, Mr. Chairman, and Members of 
the subcommittee. 

I'm Jake Netterville, managing partner of Postlethwaite & 
Netterville, a 90 person accounting firm in Baton Rouge, LA. I'm 
here today as chairman of the board of the American Institute of 
Certified Public Accountants, a national professional association. 

With me is Mark Gittenstein, former chief counsel of the Senate 
Judiciary Committee, who is serving as special counsel to the 
AICPA on civil justice matters. 

While I can speak from the experience of the accounting profes- 
sion, I'm not a lawyer. Mark can better respond to questions on 
particulars of civil litigation reform. So with your permission, Mr. 
Chairman, I'd like for him to join me at the table. 

Senator Dodd. Well, he can sit there. But let me tell you, 
everybody's got someone they want to bring, and so why don't you 
give us your testimony, and if we get into some difficult questions 
and you need a lawyer, we'll hire him for you. 

[Laughter.] 

But in the meantime, if everybody's got a backup in here, we'll 
never get through this. 

Senator DOMENICI. It's going to be on a contingency basis, how- 
ever. 

[Laughter.] 

Senator Dodd. Yes, I'm sure. 

Senator Domenici. It's nice to have you back in the Senate too, 
I would say. 



300 

Mr. Netterville. Let me say at the outset that we're not here 
to try to close the courthouse door on victims of fraud, nor do we 
wish to shield knowing perpetrators of fraud from any liability to 
which the present system exposes them. We propose no such thing. 

But the current system is broken, plain and simple. The evidence 
is compelling and can no longer be ignored. The securities litigation 
system is actually obstructing the strong financial reporting that 
investors need. It prevents defrauded investors from recovering 
anything but a few cents on the dollar. And it fails to deter fraud 
because meritorious and non-meritorious claims are treated the 
same. 

If all cases have the same settlement value, regardless of merit, 
if real con artists in management are treated the same as innocent 
managers, if accounting firms with crooked CPA's are treated the 
same as firms with accountants who have no intent to deceive, how 
could this system do any more than breed cynicism, rather than 
deter fraud? 

In fact, the data supplied at last month's hearings by the oppo- 
nents of securities litigation reform actually make this case. For ex- 
ample, I asked Mr. Gittenstein to analyze the data supplied at that 
hearing by Mr. Lerach, a plaintiffs attorney. 

Mr. Chairman, I request that this analysis be entered into the 
record. 

In the 20 settlements Mr. Lerach referred to, the average share- 
holder who sued, recovered a mere 14 cents on the dollar of the 
damages claimed, a number consistent with three other studies dis- 
cussed at the panel's last hearing on these issues. And there is 
more evidence the system is broken. 

Two professors at the University of California at Berkeley have 
studied 550 companies that had information that would surprise 
market analysts if disclosed; both good news and bad news. The 
overall conclusion of the study was that managers were extremely 
reluctant to provide unexpected information that was not man- 
dated. The professors concluded it was because of the litigation 
threat. 

I would ask that this study also be made a part of the record. 

An especially unsettling effort of the liability threat was that 
managers were actually more willing to disclose bad news than to 
disclose good news. But most disturbing is the finding that over 
half, over 50 percent of the companies surveyed did not disclose in- 
formation in their possession, good or bad, that had direct market 
value to investors. That's not all, Mr. Chairman. 

Unfair and excessive liability exposure also impedes auditors' 
ability to assume new responsibilities in such areas as forward 
looking financial data. For example, the Institute, American Insti- 
tute of CPA's, is proposing a new standard which would require 
management to make disclosures on risks and uncertainties, and 
auditors to report on those disclosures. 

Wouldn't an investor like to know that the company might have 
to cover a possible cash shortage by, for example, disposing of a 
line of business? 

Yet many of the comment letters we're hearing on this new pro- 
posal are opposed to it, not on its merits, but because of the in- 



301 

creased liability exposure this new responsibility would create for 
accountants who would audit these additional disclosures. 

Mr. Chairman, I know some are concerned that somehow data 
regarding the incidence of securities fraud suits suggests that this 
is not a serious or growing problem. In fact, the data show that 
these cases are increasingly targeted at high-tech companies, the 
ones on the cutting edge of America's global international competi- 
tiveness. 

What's more, we're talking about some of the largest cases in the 
Federal courts. The average securities fraud case against the larg- 
est accounting firms, for example, is $80 million. Tnis is not your 
simple breach of contract dispute between parties. Each securities 
class-action suit involves several thousand claimants. 

For the 268 suits mentioned in these hearings, we calculate that 
the alleged damages total over $10.7 billion, further evidence of the 
magnitude of a problem that cannot be ignored by this subcommit- 
tee. 

Before we ask for your help to repair the securities litigation 
structure, however, I think it's only right for the accounting profes- 
sion to ask itself: what can CPA's do to improve the financial re- 
porting system? Let me briefly describe what we are doing. 

The AICPA has recently developed a program it believes will fur- 
ther improve the value of financial information and the public's 
confidence in it. This is our white paper on meeting the financial 
reporting needs of the future. And you have a copy of that. 

Here are just a few of our proposals: 

We heartily endorse all 25 recommendations of the Public Over- 
sight Board, and we thank them for their valuable contribution. 

We propose a new disciplinary system under which every single 
CPA will know his or her profession and will respond swiftly and 
forcefully to substandard work or professional misconduct. The 
message is clear. We will rid our profession of bad apples. 

We propose, for the first time, to close the revolving door between 
accounting firms and audit clients with a 1-year waiting period be- 
fore an audit partner can be hired by a client. 

The accounting profession will establish a systematic process for 
reviewing previous cases of fraud to learn from our past mistakes. 
And we enthusiastically endorse Representative Wyden's bill, the 
Financial Fraud Detection and Disclosure Act to facilitate this 
early detection and reporting of financial fraud. 

In conclusion, Mr. Chairman, we have a securities litigation sys- 
tem which works contrary to the basic principles of civil justice, 
and weakens the financial reporting system upon which investors 
rely. How can we fix it? 

Let me suggest a set of principles to guide the legislative remedy. 

First, reform should facilitate the disclosure of useful financial 
information and the auditing of those disclosures. 

Second, reform should increase incentives for people who are 
truly defrauded to obtain the compensation they deserve. 

Third, reform should increase incentives for innocent defendants 
to go to trial to vindicate themselves. 

And fourth, reform should deter manipulation of the judicial sys- 
tem through which some overreaching attorneys profit by pursuing 
plainly meritless cases. 



302 

The evidence is unmistakable. The securities laws are working 
exactly contrary to the principles of investor protection and civil 
justice. The problem cries out for reform. The solutions are com- 
plex, Mr. Chairman, and we're here to work with you every step 
of the way. 

Thank you. 

Senator Dodd. Thank you very much, Mr. Netterville. That was 
excellent testimony. We thank you for being here. 

Mr. Sommer, it's a pleasure to have you before the committee. I 
should have made note at the time I introduced you that you've 
had a very distinguished record of public service to this country, 
and we're all deeply indebted to you. 

As a former SEC Commissioner, and having worn a variety of 
other hats over the years, and in many different bar associations 
and the like, and today the Chairman of the Public Oversight 
Board, you've fulfilled many public responsibilities, and we're 
pleased to have you back before this committee. I presume it's be- 
come familiar surroundings to you over the years. 

Mr. Sommer. Yes. 

Senator Dodd. It's a pleasure to see you again. 

STATEMENT OF A.A. SOMMER, JR., CHAIRMAN, PUBLIC OVER- 
SIGHT BOARD, AMERICAN INSTITUTE OF CERTIFD3D PUBLIC 
ACCOUNTANTS, WASHINGTON, DC 

Mr. Sommer. Thank you for your gracious words, Mr. Chairman. 

Mr. Chairman, Members of the subcommittee, on behalf of the 
Public Oversight Board and myself, we appreciate the opportunity 
to be here before you and discuss this very important topic. 

While time is scarce, I would like to say a word about what the 
Public Oversight Board is. It was organized in 1977 to oversee a 
new program initiated by the AICPA to compel firms or to cause 
firms that audited publicly held companies to undergo periodic peer 
reviews. 

The purpose of the Public Oversight Board was to assure that 
that program was carried out in the public interest, and not simply 
for the benefit of the accounting profession. The Board consists of 
five people, it is independent. While its financing comes from the 
dues of the members of the program it oversees, it has absolutely 
unbridled discretion as to how it will spend money, how much it 
will spend, what it will pay its staff, what it will pay its members, 
or who will be on the board. It is totally unbridled and it can only 
be abolished if the entire program is abolished, which is unthink- 
able, given the place it has in the self-regulatory pattern. 

John McCloy was the first chairman, a very distinguished man 
who established standards of integrity and independence that all of 
his successors and hopefully the present incumbents in office have 
preserved. 

You know many of those people who are on that board. We have: 
Mel Laird, former Secretary of Defense, a very distinguished 
former Member of the House; Paul McCracken, former Chairman 
of the Council of Economic Advisers; Bob Froehlke, who was the 
Secretary of the Army and served after that with the distinction as 
Chairman of Equitable Life and IDS Mutual Funds; and Bob 



303 

Mautz, who is a very distinguished former accounting educator, re- 
tired accounting educator. 

In the aggregate, we have 42 years of experience on this board, 
and it has given us a unique vantage point from which to judge the 
problems of the accounting profession, it's shortcomings, and what 
should be done to make it a stronger profession, able to perform 
its activities and its responsibilities better. 

We had observed for some time the problem of litigation in the 
profession, and we had intended, at some point, to speak out on 
that and other problems. Our work was hastened somewhat when 
we were asked by leaders of the profession whether we would sup- 
port the effort to secure legislation that would provide for separate 
and proportionate liability, rather than joint and several, as a 
means of allocating damages. 

However, our study indicated to us that litigation was only a 
part of the problem confronting the profession. The major problem, 
to use a term that has been commonly used in many contexts, is 
that there's an expectation gap. Some of that is because people 
don't understand what financial statements are and what an audit 
means. But more importantly, there is a responsibility, in our judg- 
ment, for the profession to undertake additional measures to close 
that gap. 

In the report that you received when we first issued it in March, 
and additional copies of which were delivered to your offices yester- 
day, we set forth 25 recommendations addressed to various parties, 
including preeminently the accounting profession, as to things that 
should be done to close the expectation gap and increase the credi- 
bility of financial statements and hopefully, as a byproduct, reduce 
litigation risk. 

Among these are: Increased measures to detect fraud; reporting 
by auditors on internal controls; greater skepticism in audits; and 
reporting on risks and uncertainties, as mentioned by Mr. 
Netterville. We recommend radical changes in some of the rules 
and practices that prevail. 

Our perception of the public interest is that there must be a 
healthy, dynamic, informed auditing function in this country if we 
are to preserve our capitalistic system where lenders and equity in- 
vestors provide the capital we need to create jobs and continue the 
growth of our economy. 

Audits must be performed by people who are well-trained, who 
are competent, and who have integrity, competence and independ- 
ence. If we cease to have people like that in the profession, the pub- 
lic interest will be severely damaged. 

We believe that the litigation threat that exists today with re- 
gard to the accounting profession poses a real danger that that 
kind of a profession is going to be undermined in a number of 
ways. 

For one thing, many informed observers believe that the amounts 
of damages being sought in many of these cases, and some of the 
judgments that have been rendered, create a likelihood that one or 
more of the major firms may collapse, with resulting liability not 
only for the firm, but for the individual partners who cannot be in- 
sulated under the present procedures from liability. 



304 

If that occurs, I think it is easy to imagine the extent to which 
there will be an exodus from the profession, the extent to which 
people will refuse to join the profession if they are going to be ex- 
posed to this massive exposure to liability, not only to their capital 
in the firm, but to their personal fortunes. 

There is evidence today that there is already a reluctance on the 
part of students coming out of business schools to enter this profes- 
sion. There is probably more than one cause of that, but certainly 
fear of litigation and trie liability that they may be assuming is one 
of those. 

Furthermore, as Mr. Netterville mentioned, firms today are re- 
luctant to undertake responsibility for auditing and reporting upon 
additional kinds of information that business and investors need, 
such as forward-looking information and reporting on risks and un- 
certainties. A number of types of information have become nec- 
essary for sound investing, and that information is not enjoying the 
additional credibility that flows from an auditor's opinion. 

The change that is proposed for allocating damages, in our esti- 
mation, is one step and, frankly, a relatively small one in the direc- 
tion of remedying the problem that exists. 

All of us have sympathy for the investor who is defrauded. All 
of us have sympathy for the person who is a loser because of some 
misdeed on the part of anyone; auditor, management, directors, or 
who. However, we believe it is only fair that that damage should 
be allocated on the basis of the extent to which each of the defend- 
ant parties has been responsible for the harm. And we do not be- 
lieve that anyone, not only accountants, but other people as well, 
should be held responsible for damages that they did not cause. 
There is a need today for more radical reform in the tort system 
than has been proposed. 

One of our responsibilities at the POB — and I only have about 
one minute, Mr. Chairman — one of our responsibilities is to review 
all of the cases that are filed against auditing firms that relate to 
publicly held companies. 

We review those very carefully. Time and again, we encounter 
cases that are demonstrably misfired, demonstrably not appro- 
priate cases to be brought against the auditor. Some of those cases 
involve charges of misdeeds on the part of an auditor at a time 
when the auditor wasn't even retained by the company. 

Congress should consider favorably a proposal with regard to the 
allocation of damages for wrongdoing. But there is a broader and 
deeper problem here that I would hope Congress in due course will 
address. 

Thank you very much for your attention, and again, I appreciate 
the opportunity to appear before you. 

Senator Dodd. Thank you very much, Mr. Sommer. 

I'm going to jump over Professor Briloff, if you don't mind. Mr. 
Whitworth has a meeting he's committed to, that he's going to then 
come back from, as I understand it. So let's take Mr. Whitworth's 
testimony now. We'll then excuse you, but we expect you to come 
on right back after that meeting, and I appreciate the significance 
of the meeting. I'm sure your colleagues at the table won't mind 
you going ahead. 



305 

STATEMENT OF RALPH V. WHITWORTH, PRESIDENT, UNITED 
SHAREHOLDERS ASSOCIATION, WASHINGTON, DC 

Mr. Whitworth. Thank you. I appreciate that, Mr. Chairman. 

I iust wanted to start out by commending the subcommittee for 
holding these hearings, and commending you, Mr. Chairman, and 
the subcommittee for the powerful commitment that you've had 
over the past several years to individual investor protection, par- 
ticularly in the late 1980's, the turmoil there, and with the partner- 
ship rollups and now on this issue. Of course, Til just summarize 
my remarks, and you'll accept the full testimony in the record. 

I'm here to say that our system of private rights of action has 
evolved into a game of gotcha litigation, and that 

Senator Dodd. Why don't you tell us a bit about who you rep- 
resent. 

Mr. Whitworth. Yes. I'm with the United Shareholders Associa- 
tion, 65,000 members, non-profit, based here in Washington. We 
have members in all 50 States and in fact in some foreign coun- 
tries. 

I think my dad used to tell me, he said, you've got to watch it 
because sometimes, when you're up to your neck in alligators, you 
forget that you were originally there to drain the swamp. I think 
that's what we're looking at here, because when I went back to the 
legislative history on this issue, in fact, I took it clear back to Jus- 
tice Brandies at the turn of the century when he first started talk- 
ing about this, and looked at the legislative history, looked at the 
comments in the implementing regulations at the time that these 
rules were set up. And the record bears absolutely no resemblance 
to what we see today as far as winners and losers and who the 
players are. 

People talk about this being an extraordinarily complex issue 
and arcane. But if we step back and look at what we were trying 
to do originally with these regulations, we were trying to catch per- 
petrators of fraud and penalize them, trying to compensate victims, 
and trying to deter future fraud. 

All you have to do now is see if that's happening, and it abso- 
lutely is not. In fact, the victims are paying now, the victims that 
we were trying to protect at that time. 

The system of penalties and incentives that Congress con- 
templated at that time has turned upside down. Today, the win- 
ners in these suits are invariably lawyers who collect contingency 
fees, professional plaintiffs, if you can believe, who for all intents 
and purposes are paid bonuses to bring these cases and in cases 
where real fraud happened, the executives and the board members, 
who use corporate funds and corporate funded insurance policies to 
escape personal liability. 

You very seldom see a case where personal liability is exacted 
against an officer or a director because of settlements and insur- 
ance policies. And the one constant in this is that shareholders pay 
for all of it. In fact, in many cases, shareholders get hit three 
times. They get hit for the original fraud, if there was fraud. They 
get hit when the suit is filed because the stock goes down then. 
Then, they get hit when they get soaked when these contingency 
fees are paid. Finally, they end up with pennies on the dollar, 
which you've heard plenty about. But even when these pennies on 



306 

the dollar trickle down to the shareholders, to the extent that they 
still own stock in the company, they're being paid with their own 
money. Or, if an insurance company pays for it, they pay for in- 
creased insurance premiums through their investment in the com- 
pany. 

For this system to effectively deter fraud, compensate victims 
and penalize perpetrators, we've got to realign the incentives. We 
need more incentives to press meritorious cases to ultimate adju- 
dication, and we need fewer incentives to file frivolous cases. That 
seems axiomatic, but that's the heart of it. In fact, today, the meri- 
torious cases and the marginal cases are often treated exactly the 
same because the incentive of the managers of these lawsuit fac- 
tories incentive is to maximize their share of the settlement at the 
earliest possible time, and move on to the next case. 

I use the analogy of maximizing profits because I'm convinced 
that many of these firms analyze these cases, just like you analyze 
a business proposition. They apply present value analysis to their 
expenses, they present value their resources, find out when they 
might get a settlement and how much it might be, and decide 
whether to take the case. 

In fact, I had a conversation with a partner in one of these 
prominent firms, and I'm going to give you a little bit on that con- 
versation. Incidentally, one of the plaintiffs lawyers that I was 
talking to earlier this week said, "well, you can't tell that story be- 
cause it's hearsay." So I'll just tell you that this is hearsay, but I 
think it's very valuable that you 

[Laughter.] 

— that you 

Senator Dodd. You may need a lawyer over there, I think. 

[Laughter.] 

Mr. Whitworth. — that you hear it. 

OK So here's what I was told. That the firm has to be prepared, 
they need to be set up to strike very quickly, and we heard earlier 
why that was. 

And that the suits are filed — this is important — they file them 
against the officers and directors in their capacity as individuals, 
and they file suit against the company as an entity. So they file 
two sets of suits. 

Now once a colorable case is on file, one that the court says, OK, 
let's go to discovery, then a war of attrition begins. And the objec- 
tive during that process is to get the officers and directors on depo- 
sition. Because as soon as the court allows the depositions to begin, 
that's when the company starts talking settlement. 

Now, remember they're talking settlement, not with their money, 
but with the shareholders' money or an insurance company's. 

So now we've got the heat turned up on the officers, the settle- 
ment talks begin, and invariably, you can check all the records on 
this, these suits are settled like this. They drop all the suits 
against the officers and directors, and they settle the suit against 
the company, OK. And the company's funds or an insurance policy 
are used to settle that suit. 

I was told that the secret to success in this process is that the 
law firm has to have the staying power to get to that stage where 
the risks cross over and the company says, let's get this thing set- 



307 

tied." So the law firms have to have finances and resources to stay 
in the game. It's not just any law firm that can do this. 

When they do get to that point, then it's automatically, if you 
look at the economics, going to be settled, because the insurance 
company, and the corporation say, look, if we can settle it for this 
$10 or $20 million, and we compare that to the risk that we have 
in the final judgment and the cost of going to trial. . . . They make 
a business decision. 

OK, think of the dynamics of that situation just for a moment. 
We have a central concept in our legal system that the client de- 
cides when to settle. I think that's clear to everybody. But in these 
cases, we have diffuse clients, we have too many clients to make 
that decision, so that decision is taken on by lawyers and named 
plaintiffs, who recommend a settlement. 

But how can these representatives be objective when they've got 
these large expenses invested, they have the potential to get a big 
contingency fee, and when the named plaintiff stands to get a 
handsome bonus. Yes, they pay these plaintiffs bonuses very often. 

So these are not objective people deciding that issue. Sure, they 
have notices to shareholders of the settlement. But essentially, the 
clients' role is being overtaken or supplanted by people whose in- 
terests diverge radically from that of the clients. We've got to set 
up our system to guard against the conflict there. 

We hear about a litigation crisis in this country. I think the 
American people would be shocked if they knew that we actually 
pay, that our system sanctions paying people to bring lawsuits! 
And that's what these plaintiffs' bonuses are. I think to most peo- 
ple it just wouldn't pass the smell test. 

Finally, Mr. Chairman, these dynamics work great for the law 
firms and for the perpetrators of fraud who aren't penalized, but 
they have an insidious effect on innocent companies, our securities 
markets, and most of all, the shareholders who pay the bill. 

Now the answer isn't to eliminate the suits or to apply the Eng- 
lish rule. That would be like closing all the banks to stop Jesse 
James. But there is a proper role for these suits, in fact, a critical 
role, for the three reasons I mentioned. 

Unfortunately, these functions are subordinated to legal fee 
maximization, and that's what needs to be corrected. We need more 
safeguards to defeat that divergence of interests in that settlement 
discussion. That's the heart of it, I think. 

If you look to Justice Brandies, he's the father of the disclosure 
philosophy of our securities laws, I guess we could say. And he 
wrote a book, "Other People's Money" back in 1914, remember we 
had a play recently, I think it debuted in Hartford actually, named 
"Other People's Money," but this was the book. Justice Brandies 
said something very powerful in that book. He said that publicity 
is a powerful remedy for social and business diseases, and that 
sunlight is the best disinfectant. And that electric light is the most 
efficient policeman. 

Now the shareholders need more sunlight shined on the legal 
fees and on what bonuses the named plaintiffs are getting in these 
settlements. Right now the notices of settlement say the sharehold- 
ers will receive a substantial benefit, and they should go on to say 
that the lawyers shall receive a lavish benefit, and so will the 



308 

named plaintiff. But they don't. They do give a figure, though. I 
don't want to misrepresent that, but I think it should be detailed 
and pointed out in bold letters. 

Finally, beyond that, look closely at Senator Domenici's bill, par- 
ticularly the area of joint and several liabilities as applied to ac- 
counting firms, and also his approach to fee shifting. I think that's 
an excellent place to start. 

I'll be happy to elaborate on the testimony with the Staff, or 
work with you in any way from here. 

Senator Dodd. Thank you very much, Mr. Whitworth. 

Mr. Whitworth. I'll be right back. 

Senator Dodd. You're going to come back? 

Mr. Whitworth. Yes. I'm going to run to the Hart Building. 

Senator Dodd. All right, very good. 

Professor Briloff, we appreciate your presence here today. You 
are certainly well known to anyone who has been involved in these 
issues over the years, and your concerns predate any of the big 
name cases of the recent past. So it is a pleasure to have you here 
before the committee. 

STATEMENT OF ABRAHAM J. BRILOFF, PHX)., PROFESSOR 
EMERITUS OF ACCOUNTING, BARUCH COLLEGE, CUNY, NEW 
YORK, NY 

Mr. Briloff. Thank you, Mr. Chairman. 

In thinking through the brief remarks I want to give beyond my 
prepared text summary, I thought that the best way of approaching 
it would be consistent with the title theme that I gave to the pre- 
pared statement: Who are we? Why are we here? 

I will begin by asking the questions: Who am I and why am I 
here? 

Senator Dodd. You are not a candidate for Vice President, are 
you? 

[Laughter.] 

Mr. Briloff. I have expressed my appreciation to Admiral 
Stockdale for those questions. 

[Laughter.] 

But actually, Mr. Chairman, in all seriousness those questions 
that Admiral Stockdale asked were very profound. If we think 
back, they are very analogous with the questions which were asked 
two millennia ago by Rabbi Hillel when he said: 

If I am not for myself, who will be? But if I am for myself alone, what am 
I? If not now, when? 

I am Abraham Briloff, Emanuel Sachs distinguished professor 
emeritus of the Bernard Baruch College of the City University of 
New York. Why am I here? 

The committee invited me, and I am very, very privileged to have 
accepted that invitation because it implies that, despite the years, 
there may be something that I might be able to contribute to this 
dialog. 

I am not here to represent the accounting establishment on the 
right, nor the legal profession directly to my left, and otherwise. I 
believe that I am here to represent the traditional auditing profes- 
sion as it was contemplated, and the auditing profession which so- 



309 

ciety requires most urgently and compellingly, consistent with soci- 
ety's expectations. 

My friend Al Sommer referred to "the expectations gap." There 
is that. But society's expectations are precisely what we require in 
order to make the corporations implement, the corporate engine 
which is essential to our capitalistic society, function effectively 
and efficiently. 

And so it is that in my thinking through for these brief remarks 
I am not thinking pathologically m terms of the litigation and the 
lawsuit; instead I want to think prophylactically: what must our 
profession do to meet the social expectations and requirements of 
the totality of our society? 

I believe we have to go far beyond that which the Public Over- 
sight Board and the American Institute promised in terms of the 
various programs that they have outlined. 

We do not really have, as I see it, a litigation crisis. We have an 
identity crisis. 

The auditing profession does not know, or the auditors really do 
not know to whom they are responsible for what, and when. 

The public presumes that it is the auditor who is fearlessly writ- 
ing the record of the corporate history in a period of time. Not so. 
The auditor is merely lending his so-called "attest function" to say 
that that which the corporate management has done somehow or 
other can be subsumed in our so-called "Book of GAAP," Generally 
Accepted Accounting Principles. 

Now the Public Oversight Board saw that in their special report. 
They said: "Look, the auditor sometimes gets caught up." The client 
sees a liberal interpretation — I sometimes refer to it as a sneaky 
or a funky interpretation 

[Laughter.] 

— which somehow the auditor cannot absolutely fight against; 
and so, the auditor capitulates. 

Now the probabilities are that at that moment of capitulation it 
is only a million dollars of funkiness. But having gotten over that 
threshold, the next year it is $10 million, and then $20 million. 
And what happens when it becomes $2 billion. 

Well, the auditors then say: "You know, this is a major problem." 
We will now take it to the Financial Accounting Standards Board 
and the Emerging Issues Task Force and tell them that there is 
this enormous problem which should never have been capitulated 
to. 

Correspondingly, those statements [from the AICPA and POB] 
express the urgency of the auditor's independence, which I main- 
tain is the sine qua non of our relationship, with the responsibility. 
But they do not talk in terms of where it is that the preponderant 
fees are now coming from — namely, management advisory and con- 
sultative service. 

What they have done generally — especially the major firms — is to 
use the audit as a loss leader. Bid it in. 

Competitive bidding unfortunately was required under the Rules 
of the Federal Trade Commission. Bid in the audit cheap so that 
maybe we can then get the entre into these lucrative services. 

Now the grievous cost on that is not only the poor audit that 
might come forth, or the loss of independence, but as a result of 



310 

the audit being brought in cheap those who are identified within 
the firms with the audit function. 

Students come back to me and say: "If you are there, you are 
doing time and paying your dues." You get your experience and try 
to move to one of the more glamorous fields — namely, taxation to 
some degree, but management consultant. That is where the best 
and the brightest go. The work is easier. The glamour is greatest. 
And the compensation is highest. 

So it is that there is a great deal that needs to be done prophy- 
lactically. There is the commitment to internal control that the 
AICPA White Paper refers to. 

Great! But then I ask, why did they not go along with the SEC 
Regulations' proposal in 1979 when the SEC proposed just that? 
Namely, the opinion for management with respect to internal con- 
trol with the attestation thereto by the independent auditor? 

I recall vividly the vice president of auditing of the American In- 
stitute of CPA's speaking aggressively against that as to what that 
would do. 

So they are now resurrecting something that might have been 
appropriate then, but I want to take that point. I want to take that 
point — namely, it is a good one: review the internal control system; 
but what does "internal control system" mean to me? 

Not just to make sure that the cash was counted and the inven- 
tory is in place and whatever it is, but that the total process within 
the corporate structure, the way in which judgment calls are made 
with respect to the determination of which accounting precept 
should or should not apply, all of that should be fully and effec- 
tively disciplined and documented and the independent auditor 
should make certain, absolutely certain in the case of publicly held 
corporations, that all of this is then submitted fully, intensely, and 
vitally to the Independent Audit Committee, ana that the Inde- 
pendent Audit Committee consider their tasks as something com- 
pletely different from the near sinecure and honorific appointment. 

The Audit Committee, as Justice Goldberg said some years ago, 
ought to have available to them a consortium of experts to the ex- 
tent required so that the Independent Audit Committee can then 
sit in judgment. 

There is a great deal that needs to be done in order to perfect 
the corporate engine, which is a vital engine. It needs to be pro- 
tected not just for shareholders, not just for creditors, but for the 
entire capitalistic society because the engine of our capitalistic soci- 
ety is within the corporation. 

If it functions effectively, our society will function effectively. To 
the extent that there are shortcomings and shortfalls, then they 
have to be corrected. 

So it is with respect to the litigation crisis, for the reasons indi- 
cated in the final segment of my prepared statement, I appreciate 
the sense of outrage where there are frivolous actions, and I 
empathize with my colleagues with respect to that. 

But here I cannot help but recall the circumstance of the librar- 
ian who required additional space and turned to the administration 
for budgetary appropriation for an expansion of the library, and 
they turned to him and said: "Now, look. You know that 80 percent 



311 

of the books in this library are not read. Why not therefore remove 
them and then you will have enough space?" 

The librarian said, "you are absolutely right." But now tell us, 
which is the 80 percent to be removed? I do not know, and you do 
not know. 

Could the judge really know at the outset — at least as I see it — 
which actions are frivolous? 

I knew when Saul Steinberg sued me because he did not like 
what I was writing that he was engaging in a frivolous pursuit, 
and I was angry at all the time I had to devote in discovery and 
depositions of why I wrote, how I wrote, what I used, and all of the 
drafts that were prepared along the way. 

I was pleased with the summary judgment handed down against 
him. In that case, of course, he had the deep pocket — namely, he 
was using his shareholders' money to pursue me. I was angry, as 
my statement says, but I came to the conclusion that our judicial 
process is the worst of all possible systems, excepting for all the 
others. 

So again I thank you so much for giving me these moments to 
share some of the thoughts. I would, of course, be pleased to an- 
swer any specific questions you might have as to what I said, 
wrote, heard, or what I may have said previously. 

Thank you. 

Senator Dodd. Professor, thank you very much. 

You would not be a bad candidate for vice president after that 
statement. 

[Laughter.] 

We appreciate immensely your presence here today. 

Our next witness is Mr. Weiss. We thank you for being here. We 
had the pleasure of the company of your partner here at the last 
hearing. So we will accept your testimony. 

Senator Domenici. Mr. Chairman, before you do that could I also 
join in thanking Professor Briloff? 

I do not know you, and I do not know as much about you as I 
should, but I greatly appreciate the wisdom you have offered us 
today and thank you so much for making the trip here. 

Senator Dodd. Very thoughtful. 

Mr. Briloff. Thank you. 

Senator Dodd. Mr. Weiss, that is a hard act to follow. 

STATEMENT OF MELVYN I. WEISS, ESQUIRE, PARTNER, 
MILBERG WEISS BERSHAD HYNES & LERACH, NEW YORK, NY 

Mr. Weiss. You had better believe it, Mr. Chairman. 

One of the greatest privileges in my life was to deliver the Briloff 
lecture at the University of Binghamton and SUNY this past year 
in which I spoke 

Senator Dodd. Pull that microphone closer to you if you would, 
Mr. Weiss. 

Mr. Weiss. — at which time I spoke a lot about the problems of 
the accounting profession. 

I was very grateful to the professor for being there with me that 

da y- 

This is a very sad occasion for me because I sit here listening to 
so many misstatements about what has been going on in the litiga- 



312 

tion process, and the reasons for litigation, and the need for litiga- 
tion, and I only have 5 minutes. I cannot cover it in 5 minutes, but 
I am going to try to cover highlights. 

There has been 60 years of failure by the accounting profession. 
There is no question about it. All you have to do is read the ac- 
counting profession's submissions to this committee. 

They admit it. They also admit that there is no litigation explo- 
sion. They show statistics that contradict their words. They say 
that in the last three years the number of litigations has declined 
30 percent from 191 to 142. 

The AICPA sends out other literature which shows that there 
has been a steady 50 litigations per year arising out of audit work 
over the last 10 years — no "explosion." But they are coming in here, 
despite this constant failure to do their job because every now and 
then somebody takes them to task. 

Now what is the failure, really? The failure is one of independ- 
ence. 

What does that mean? It means that they are serving as 
handmaidens and henchmen for clients who have perpetrated 
many, many wrongs over a long period of time, and they have per- 
mitted these wrongs to go undetected until catastrophic events 
occur that cause these companies' stocks to plummet or to go out 
of business. Make no mistake about it. 

Their failures are the failures of those they serve as well. That 
means that there are victims out there who have been victimized 
by these failures. 

Would a lawyer bring a lawsuit as a class action under rule 23 
that that lawyer thought was frivolous? That lawyer would have to 
be insane. 

It is one kind of case in our system that has more protections 
built in than any other kind. It is truly fishbowl litigation. A law- 
yer files a lawsuit as a class action, denominates it as such, and 
immediately becomes a fiduciary — a fiduciary to the class and to 
the court and, as an officer of the court, undertakes many respon- 
sibilities. 

One of the major objectives of our judiciary today, Members of 
the committee, is to be able to handle litigation that is brought to 
it, given its limited resources, its inadequate number of judges — be- 
cause the judgeships have not been filled. They have big problems 
in our courts. 

So judges put pressure on litigants to get the cases settled. And 
as officers of the court, we have that responsibility. It is the first 
thing on every agenda when we go to a pretrial conference in a 
complex litigation. It is on every agenda of every meeting of every 
Federal judge I know that handles complex cases. 

I am now representing Phar-Mor, a catastrophic fraud with 
many, many victims. Judge Zeigler in the Eastern District of Penn- 
sylvania was assigned that case because he knows how to handle 
settlements of complex litigations. 

If we did not have Judge Pollock in New York where I labored 
for 2 years in the Drexel Miliken cases, where together with the 
FDIC and the RTC we recovered over $2 billion for victims of 
wrongdoing because he pushed us to settle and whipped us into a 



313 

settlement mode, our victims might be in litigation for 10, 15 years 
without remedies. 

We perform the kind of role that, as officers of the court, we are 
responsible to perform. 

If there are settlements, make no mistake about this, they come 
because, as the defendants often tell us, you cannot settle — we can- 
not settle with you until you draw blood. Did you ever hear that 
phrase? Anybody who is a trial lawyer has heard that phrase: Until 
you draw blood! 

And what does that mean? We have to get the evidence to show 
them that if they go to trial they are going to lose, or they have 
a very serious risk of loss. Then the judge appoints a settlement 
master, or a settlement judge, another Federal judge, and starts 
whipping us into a settlement mode. 

Why? So that the judiciary can function and that all the cases 
that come before it can be handled, criminal and civil. 

It is very difficult to refute arguments that somebody who sold 
stock 10 months before the stock collapsed was or was not a wrong- 
doer. When the judge takes the case away from the jury, one will 
never know. 

But trust me when I tell you that I have cases, many of them, 
where the wrongs that gave rise to the subsequent collapses oc- 
curred or started more than 10 months before the collapses. 

I have a case right now in Connecticut, the Lone Star Industries 
case, where the accountants were dismissed out of the lawsuit on 
a 9(b) motion. Talk about protections. Talk about what the account- 
ants have to protect them. Talk about what wrongdoers have to 
protect them. 

Talk about 9(b). A very tough hurdle. A very tough pleading hur- 
dle for a plaintiff to get over. 

Talk about rule 11. 

Talk about Summary Judgment grants despite lots of evidence of 
wrongdoing like I had exercised against me in the Convergent 
Technologies case, and despite the fact that I was thrown out of 
court at the District Court level I was offered $10 million to settle 
on appeal and I turned it down because I did not think it was ade- 
quate. 

I have made my reputation, and my firm has made its reputation 
because we just do not settle. We settle when we think our client 
is getting the right results in the circumstance, and every cir- 
cumstance is different and unique. We are very conscientious about 
it 

I would be happy to answer any other questions. There is very 
little time here, and I do not want to take up too much. 

Senator Dodd. Well I appreciate that. The restraint is on every- 
body in that sense, Mr. Weiss. 

We appreciate your testimony. 

Mr. Weiss. Thank you. 

Senator Dodd. Mr. Bowman, thank you for being here. 



314 

STATEMENT OF ROBERT A. BOWMAN, EXECUTIVE VICE PRESI- 
DENT AND CHffiF FINANCIAL OFFICER, ITT CORPORATION, 
ON BEHALF OF FINANCIAL EXECUTIVES INSTITUTE, NEW 
YORK, NY 

Mr. Bowman. Good morning, Chairman Dodd. It is a pleasure to 
be here. 

And thank you to Senator Riegle for his kind remarks. Leaving 
Michigan was tough, but joining you in Connecticut has been a 
pleasant experience for the last 4 weeks. 

I was ably represented in Michigan by two outstanding Senators 
and I know I will receive the same kind of treatment there, and 
I appreciate that. 

I am here today, Mr. Chairman, on behalf of FEI, Financial Ex- 
ecutives Institute, representing 14,000 financial officers and some 
8,000 businesses, and probably trillions of dollars in outstanding 
securities. No one group probably has as much at stake in the secu- 
rities market than FEI and its affiliated companies. Prior to that, 
as you know, I worked in Michigan. 

We will not want to leave out the fact that municipalities, large 
and small, also rely tremendously on the securities market. 

The subcommittee today is addressing a number of important is- 
sues: specifically, litigation, reform, and also Congressman Wyden's 
bill relating to the proper use of auditors, and when auditors can 
tell the SEC and should tell the SEC in terms of wrongdoing. 

I am going to confine my remarks to Congressman Wyden's bill. 

Underpinning any security transaction for a new entity and an 
existing entity, debt or equity, is prompt and full disclosure. If you 
lose that, we all run into trouble. It is what underwrote anything 
we did in Michigan, and it is what underwrites all the FEI mem- 
bers. 

Turning specifically to Congressman Wyden's bill, there are two 
questions which I wish to address. 

The first is timely reporting by the public auditors to senior man- 
agement and to the SEC for material illegality and the other has 
been raised by my other colleagues on this panel: Is there a proper 
time, and are there more proper oversight controls that public 
auditors should engage in in the near-term future? 

First, on the proper accounting by auditors to senior manage- 
ment and ultimately the SEC if tnere is alleged material illegality. 
We fully concur with Congressman Wyden's bill: Prompt and full 
disclosure of any alleged illegality should go to the SEC as soon as 
is practicable. 

We assume and hope that that is the current case and strongly 
support passage of this bill as quickly as possible. We have sup- 
ported this bill for some time, and FEI will continue to support it 
and its precepts. 

Second: Are other steps necessary by the public and auditors to 
ensure the integrity of the internal management controls? 

This is an issue where we will part company with some of our 
friends in the auditing profession. We fundamentally believe that 
management is responsible for its internal controls, and manage- 
ment alone. Management puts them in place, and management is 
responsible to its shareholders, its lenders, and its employees for 
proper internal controls. 



315 

We believe that the management discussion section in the report 
is of paramount importance, and we at ITT and I am sure my col- 
leagues spent a great deal of time on that section to try to make 
an accurate representation of what we as management believe. 

Therefore, we do not believe it is necessary, and in fact we be- 
lieve it would be counterproductive if we asked the public auditors 
to assume further responsibilities beyond that of representing to 
the public a true and accurate picture. 

In fact, we think that the users of audited financial statements 
that go well beyond investors have a right to expect that, as part 
of that annual audit for an entire year — which is published once a 
year, or quarterly — the outside auditor's examination of the compa- 
ny's transactions and the amounts and disclosures in the financial 
statement extends to adequate testing of the internal controls in 
sufficient depth — in sufficient depth — to conclude that the quality 
and reliability of such financial statements is not jeopardized. 

In other words, we think that the shareholders, the lenders, the 
public, anyone who reads that end report should expect that when 
the auditor signs his or her opinion, when they put that name on 
the bottom line, that those financial statements are fairly pre- 
sented. 

Any public accounting firm, any firm, that suggests to you and 
this committee that it does not understand a company's internal 
controls and they still sign that letter of opinion we think is engag- 
ing in sophistry. 

We would not expect any public accounting firm to sign its name 
without understanding fully and completely the internal controls of 
a company, large or small. 

A lot of these other actions they are contemplating we believe are 
unnecessary. Moreover, I say they are counterproductive. 

We estimate, the FEI estimates, that to do these kinds of addi- 
tional roles for public auditors could add as much as 20 percent 
more to the annual auditing bill — right now currently $5 billion to 
the shareholders of this country; $5 billion. Another 20 percent 
would be an additional $1 billion. 

Candidly, that is a tax increase corporate America does not need. 

As I said before, we first of all believe that management's role 
is properly in executing and discussing its internal controls. 

The public auditor's role is trying to examine the final financial 
numbers and make sure that they are true and accurate. 

Mr. Chairman, I note that the green light is still on, but I am 
going to exercise a privilege and end early in an effort to get to my 
colleague at the SIA. 

I would conclude that we believe that capital fund raising activi- 
ties is one of America's premiere industries, if not its premiere in- 
dustry. We think that anything this committee can do to help that 
industry would be in great need. 

I thank you for your time, Mr. Chairman, and look forward to 
questions. 

Senator Dodd. Well, thank you. 

I thank you for your comments. Obviously that is why we are 
here. We can talk about deficit reduction and a lot of other things 
to encourage economic growth and expansion, but under our system 



316 

it is our ability to attract capital and give investors confidence to 
invest in our industries and our businesses that creates growth. 

Ultimately that is going to be the deficit reduction plan that 
works. Everything else we may try to do from a public policy stand- 
point will fail if we fail to address issues related to the issues of 
capital formation. 

That is why this is so critically important. 

Senator Dodd. Marc, it is a pleasure to have you before the com- 
mittee. 

STATEMENT OF MARC E. LACKRITZ, PRESIDENT, SECURITIES 
INDUSTRY ASSOCIATION, WASHINGTON, DC 

Mr. Lackritz. Thank you, Mr. Chairman. 

I want to thank you and the Members of the subcommittee for 
the opportunity to testify today. I am Marc Lackritz, president of 
the Securities Industry Association. It is a pleasure to be with you 
to present SIA's views on the important topic of litigation reform. 

The securities industry and the capital markets play a critical 
role in the United States' economy. Securities firms raise capital to 
finance new industries, to expand existing businesses, to finance 
government at all levels and, most importantly, to create jobs. 

In 1992 the securities industry raised over $1.1 trillion for cor- 
porations. We raised $24 billion for new and growing companies in 
initial public offerings. We raised $772 billion in debt issues for 
Government at all levels. 

The U.S. capital markets are the most efficient, open, and liquid 
markets in the world. 

We are responding to the needs of the marketplace and are help- 
ing to restart the American economy. 

It used to be that the best advice on Wall Street was buy low/ 
sell high. Today that advice should be: buy low/sue often. 

Plaintiffs' lawyers and the professional plaintiffs are burying cor- 
porate issuers, underwriters, broker-dealers, accountants, and oth- 
ers in litigation that does little to discourage wrongdoing, but does 
much to line the pockets of the plaintiffs lawyers. 

Congress designed the securities laws to encourage full disclo- 
sure and to deter fraud. Congress never intended the securities 
laws to make issuers, underwriters, broker/dealers, and account- 
ants the guarantors of investments. Instead, Congress wanted pub- 
lic investors to have complete information about the securities that 
they were buying. 

We strongly believe in investment protection because it is both 
good public policy and good business. Public customers should re- 
ceive complete information about investments because honest mar- 
kets mean lower capital costs for all of us. 

If we were writing the securities laws today, we would set a few 
simple goals for private securities litigation. The securities laws 
should promptly and fully compensate investors who are truly 
harmed by wrongdoing because of defective disclosure or fraud. 
Plaintiffs should have to bring their cases promptly and should not 
be able to wait to see if a stock's price rises or falls. The litigation 
system should deter strike suits. 



317 

Judged by these goals, the current system misses the mark. In- 
stead, predatory plaintiffs' lawyers routinely file suit when a public 
company's stock declines. 

Studies show that these cases have a high probability of settle- 
ment regardless of the merits. Why do issuers and other defend- 
ants want to settle these cases? Because the cost of defending them 
is prohibitive. Plaintiffs' lawyers profit when they win a case, and 
face little risk for merely filing a suit. 

The lawyers lob barrages of computer-generated pleadings and 
discovery requests the defendants must satisfy. 

Corporations, underwriters, broker/dealers, and accountants 
often conclude that, even if they could win a case on a motion for 
summary judgment, the cost of paying sophisticated counsel, the 
lost time from productive work, and the other risks of litigation 
simply do not make fighting cost effective; so, the parties settle. 

The plaintiffs' lawyers and their stables of professional plaintiffs 
are imposing a private litigation tax on American business. The ef- 
fect of this tax is to drive up the cost of capital in the United 
States, limit